A derivative is a contingent claim whose payoff depends on the performance of some other financial instrument or security. For instance, an American equity call option gives the purchaser of the call the right (but not the obligation) to buy a share of equity from the issuer or writer of the call option at or before some future date at a price determined today. A credit default swap (CDS) is a credit derivative contract between two (counter)parties in which the holder makes periodic payments to the issuer in return for a payoff if the underlying financial instrument specified in the contract defaults.
A derivative contract is formally identical to a lottery, a (simple or compound) bet or gamble. Like any financial claim, any derivative is an ‘inside asset’ – it is in zero net supply. Because pay-offs associated with a derivative contract are functions of observable properties of other financial claims (prices, interest rates, default states), the derivative contract either re-packages existing underlying uncertainty or creates additional ‘artificial’ uncertainty. It would create additional extraneous uncertainty if it added some noise of its own to the fundamental, exogenous uncertainty that is presumably reflected in the features of the underlying security that determine the pay-offs of the derivative contract.
If the creation and trading of derivatives were costless, derivatives result in zero-sum redistributions of wealth between the issuers and the owners of the derivative contracts. Costless derivatives would be redundant if markets were complete. When markets are incomplete, as they are in our unfortunate universe, introducing derivatives can either lead to an increase or to a reduction in efficiency and social welfare. Lower efficiency and social welfare are possible even if creating and trading derivatives were costless. Derivatives may improve the allocation of risk, but there is no guarantee that they will. It is my contention that the unbridled explosion of certain categories of derivatives has done considerable harm, and that it is necessary to regulate all derivatives trading.
How can creating lotteries, even if they only mirror fundamental underlying uncertainty, be welfare increasing? The usual argument involves examples where there is a given quantum of ‘objective’ or ‘exogenous’ uncertainty in the world, e.g. uncertainty about endowments, technology and tastes (all assumed exogenous – only economists would treat technology and taste as exogenous, of course!). Markets for risk trading are incomplete and creating derivatives markets does not alter the objective/exogenous uncertainty in the world. Creating and trading derivatives is costless.
In such a world one can imagine a pension fund that wishes to hold default risk-free 10 year government securities, but unable to find them in the market, instead holding 10 year AAA corporate bonds and CDS to cover the default risk of these corporate securities. Provided the writer of the CDS is creditworthy, the pension fund could achieve its preferred portfolio mix. If the writer of the CDS has the appropriate capital structure and balance sheet, it could be both willing and able to bear the default risk on the corporate bonds than the pension fund. For the lottery created by a derivative contract to be welfare-increasing, it will have to produce a positive monetary pay-off for the purchaser of the derivative in exactly those ‘states of nature’ where the purchaser will be worst off, while at the same time ensuring that the corresponding negative monetary pay-off for the writer of the derivative does not hurt the writer of the derivative too badly.
It would of course be more direct to draw up contracts contingent on the exogenous uncertainty directly. If the pension fund’s ‘endowment’ were to be negatively correlated with that of some other legal entity, and if the two endowments could be observed and verified, an endowment-sharing rule could be specified that would make both parties better off. You would not start looking for contracts specifying payments that are contingent on endogenous risk, such as default risk or the behaviour of some price or interest rate.
Derivatives, insurance and gambling
Consider the CDS. The purchaser pays a premium to the writer of a CDS. That is the price of the lottery ticket, or the price of the betting slip. If the underlying security specified in the contract defaults, the writer of the CDS pays the owner of the CDS a specified amount of money. That’s the lottery prize, or the winnings of the bet. In the UK where there are more legal forms of gambling than in most other countries, many conventional financial instruments or securities have been ‘re-engineered’ as formal bets. Spread betting on exchange rates, interest rates, stock prices and now also house price indices is a popular form of investment. The reason is that earnings from gambling are not taxed. The government presumably does not tax the gains and losses from gambling because (ignoring the value added of the gambling industry) gambling winnings equal gambling losses, so if the tax code allows loss offsets, there is not much point (ignoring progressivity of taxation & other complications) in taxing the gains and losses from gambling.
Derivatives can be used to provide insurance (paying a premium to buy protection against a possible loss) or to gamble (paying a premium to acquire the opportunity to benefit from a possible gain). CDS can provide either insurance against loss or an opportunity to gamble. This is because the buyer of a CDS does not need to own the underlying security or other form of credit exposure. The buyer does not have to suffer any loss from the default event and may in fact benefit from it.
When purchasing an insurance contract, the insured party is generally expected to have an insurable interest in the event against which he takes out insurance. This simply means that he cannot be better off if the insured against event occurs than if it does not occur. Determining what constitutes an insurable interest is often complicated in practice, but simple in principle: you have an insurable interest if, when (a) the future contingency you insure against occurs and (b) the insurance contract performs (something you cannot necessarily count on, without assistance from the tax payer, if you buy your CDS from AIG), you are not better off than you would be if the insured-against future contingency did not occur.
Clearly, CDS contracts don’t require an insurable interest to be present. Many other derivatives likewise don’t require an insurable interest to be present. Short selling a share of common stock in the hope/expectation of a fall in the price of the equity without either owning or borrowing the stock (naked short selling) is an example of a derivative contract without an insurable interest.
Why should the state care about gambling through derivative contracts?
(1) Gambling is addictive
Like all forms of gambling (deliberate risk-seeking), gambling in the derivatives markets can be addictive. This may create a paternalism-based argument for regulating, restricting or even banning the activity. Having observed derivatives writers, purchasers and traders in action, it is clear that the thrill of the gamble is part of the motivation behind this activity. The monetary gains and losses figure prominently, of course, but the bungee-jumping, sky-diving, tight-rope-walking-without-a-net dimensions of derivatives trading definitely play a role. It cannot be a coincidence that there are so many more male than female traders and other operators in the financial markets. Testosterone is not underrepresented in the trading room. And the thrill of taking a wide-open position can be addictive. I wouldn’t be surprised if Gamblers Anonymous had a special chapter for derivatives gambling.
I am generically underwhelmed by arguments for protecting compos mentis adults against themselves based on paternalism, but the list of arguments would not be complete without it.
(2) Moral hazard or micro-level endogenous risk.
This is the familiar argument already mentioned before, that if the insured party (the purchaser of a CDS, for instance) can influence the likelihood of the insured-against contingency (the default of the underlying security) occurring without the writer of the insurance contract (the issuer of the CDS) being aware of this, there is an obvious case of market failure and potential source of inefficiency. It’s also likely to be an illegal form of market manipulation.
(3) Derivative contracts as “bearer lottery tickets”
Unlike most conventional lotteries, the lottery tickets created as part of many derivatives contracts are traded in secondary markets, sometimes over the counter (OTC markets), sometimes on organised exchanges. These lottery tickets or betting slips are not just traded after they are issued (sold by the writer in the ‘primary issue market’), most of these derivative contracts are bearer securities: their ownership is not registered. The owner is anonymous. Listed common stock, by contrast, is an example of what I have called a ‘registered security’. There is an ownership register, which is, at least in principle, in the public domain. Clearly, establishing the beneficial ownership of an equity share may not be a simple matter of looking in the shareowners register in the jurisdiction where stock is listed, but with bearer securities the task is hopeless.
The writer of the derivative contract does not in general know the identity of the current owner of the contract. If the writer does not know this, the supervisor and regulator, or the state agency in charge of macro-prudential supervision (typically the central bank) does not know it either. There is therefore absolutely no way to determine whether the current distribution of the ownership of derivative contracts is systemically stabilising or destabilising, whether it is too concentrated or too dispersed. When a notional gross $60 trillion worth of CDS outstanding at the peak (yes, I know it’s ‘only’ $30 trillion now and much of it is ‘offsetting’ in some ill-defined way) and possibly around $400 trillion gross outstanding of total derivatives, we are talking ignorance on a cosmic scale.
(4) Risk-seeking by the over-confident
Even if the secondary markets for derivatives functioned properly (no bubbles, no liquidity seizures, no wide-spread defaults), these secondary markets can, like the primary issue market, redistribute the additional risk represented by any derivative either in a way that improves the ultimate allocation and sharing of risk or worsens it. Once a new derivative market is created, this market can either be used to hedge existing risk or to take on additional risk. I have seen no reliable statistics on the identities of the counterparties in the leading derivatives markets. My best guess is that most of the activity is not between households and financial intermediaries or between non-financial enterprises and financial intermediaries, but among financial intermediaries, mainly among different banking or shadow-banking player. Much of this trading appears to be driven by overconfidence and hubris. I have yet to meet a trader who did not believe that he or she could not beat the market. Because collectively these traders effectively are the market, they are collectively irrational, as they cannot beat themselves. So the risk ends up being concentrated not among those most capable of bearing it, but among those most willing to bear it – those most confident of being able to bear it and profit from it.
The collective hubris of the banking sector (broadly defined to include all the shadow-banking sector institutions like hedge funds, private equity funds, SIVs, conduits, other investment funds, AIG-style insurance companies etc.) means that enormous volumes of bets are placed on the behaviour of endogenous variables. The first consequence of this is that, since derivatives trading is not costless, scarce skilled resources are diverted to what are not even games of pure redistribution. Instead these resources are diverted towards games involving the redistribution of a social pie that shrinks as more players enter the game.
The inefficient redistribution of risk that can be the by-product of the creation of new derivatives markets and their inadequate regulation can also affect the real economy through an increase in the scope and severity of defaults. Defaults, insolvency and bankruptcy are key components of a market economy based on property rights. There involve more than a redistribution of property rights (both income and control rights). They also destroy real resources. The zero-sum redistribution characteristic of derivatives contracts in a frictionless world becomes a negative-sum redistribution when default and insolvency is involved. There is a fundamental asymmetry in the market game between winners and losers: there is no such thing as super-solvency for winners. But there is such a thing as insolvency for losers, if the losses are large enough.
The easiest solution to this churning problem would be to restrict derivatives trading to insurance, pure and simple. The party purchasing the insurance should be able to demonstrate an insurable interest. CDS could only be bought and sold in combination with a matching amount of the underlying security. Ideally, it ought to be possible to for me to buy a CDS by demonstrating an insurable interest in terms of my “utility”, i.e. by demonstrating that, should the underlying security default, I would be worse off in one way or other, not necessarily because I own the underlying security. In practice, this would be wide open to abuse and manipulation.
(6) Macro-endogenous risk
Financial markets are inefficient in any of the ways specified by James Tobin in a great 1984 paper – information arbitrage efficiency, fundamental valuation efficiency, functional efficiency or Arrow-Debreu full insurance efficiency. Financial markets even often are technically inefficient. A market is technically or trading efficient if it is liquid and competitive, that is, it is possible to buy or sell large quantities with very low transaction costs, at little or no notice and without a significant impact on the market price. We have seen many examples, from the ABS markets and the commercial paper markets to the interbank markets of massive and persistent failures of technical or trading efficiency.
Even in those financial markets that are reasonably technically efficient, like the US stock market, the foreign exchange markets and the government debt markets, Tobin saw frequent departures from efficiency in the less restricted senses of the word. He accepted that financial markets possessed what he called ‘information arbitrage efficiency’ that is, that they were informationally efficient in the weak and semi-strong sense. You cannot systematically make money trading on the basis of generally available public information. Clearly, however, trading profitably on the basis of insider information is possible.
He did not believe that financial markets consistently possessed ‘fundamental valuation efficiency’: financial asset prices do not necessarily reflect the rational expectations of the future payments to which the asset gives title. Key financial markets, including the stock market, the long-term debt market and the foreign exchange market are characterised both by excess volatility and persistent misalignments, that is, prices deviating persistently from fundamental valuations.
Tobin also contested the notion that the financial markets delivered ‘value for money’ in the social sense. “the services of the system do not come cheap. An immense amount of activity takes place, and considerable resources are devoted to it.” (Tobin [1984, p. 284]). Tobin referred to this aspect of efficiency as ‘functional efficiency’. Finally, the system of financial markets can be efficient in the technical, information arbitrage, fundamental valuation and functional senses without possessing what Tobin called Arrow-Debreu full insurance efficiency, that is, without supporting Pareto-efficient economy-wide outcomes. The reason is that real world financial markets interact with labour and goods markets that are inefficient in every sense of the word.
When financial markets are inefficient, the distinction between fundamental, exogenous variables and endogenous variables disappears. CDS prices can become quasi-autonomous drivers of the bond prices. The tail can wag the dog. The redistributions of wealth associated with the execution of derivatives contracts can trigger margin calls, mark-to-market revaluations of assets and liabilities, forced liquidations of illiquid asset holdings through fire-sales in dysfunctional markets, defaults and bankruptcies. Activities in derivatives markets, including futures markets, can feed back on sport markets and real production, consumption and storage decisions.
Unbridled derivatives markets may be liquid, but the question is, to what purpose? If, as I believe, there is no economic rationale for ‘naked’ CDS positions (that is, CDS that do not insure an open default position in the underlying security), then liquidity of the CDS market only serves those who want to trade naked CDS. This, in my view, only wastes real resources through (a) churning and (b) unnecessary bankruptcies.
I want to end on an upbeat note. I believe that effective and efficient financial intermediation is a necessary condition for prosperity. To those who doubt this, I recommend a reading of two books about the true microfoundations of financial intermediation, Hernando de Soto’s, The Mystery of Capital: Why Capitalism Triumphs in the West and Fails Everywhere Else, New York: Basic Books (2000) Prosperity Unbound: Building Property Markets with Trust, by Elena Panaritis (Palgrave MacMillan 2007). If you have only time for one, read the shorter work by Elena Panaritis. It describes the fascinating story of how personal possessions (characterised through informal, insecure property rights) were turned into secure property rights and thence into productive capital through a World Bank project in Peru. The book shows the importance of local knowledge and of a deep understanding of the institutional prerequisites for a successful market economy based on collateralisable wealth (especially real estate). To raise the quality of the rule of law in the property sector to the point small businesses can credibly offer land and other real estate as collateral for formal sector finance requires a formal titling authority, a state capable of reliably maintaining property records, a functional judicial system, corruption levels bounded from above etc.
The world described in these books, where the foundations of a productive market economy are being put in place, appears light years removed from the world of Wall Street and the City of London. In Peru, access to formal sector finance on reasonable terms thanks to the newly created ability to offer collateral and perfect security interest, has lifted many out of grinding poverty. In Wall Street and the City of London, massive resources and lobbying power were devoted to turning complex, long-term relationships into tradable securities – preferably into tradable bearer securities, even when the informational preconditions for this transformation to be effective were not satisfied. Increasingly, as in the case of bearer instruments like mortgage-backed securities for instance, the ultimate issuer and the current owner of the instrument knew nothing about each other. And even with simpler bearer securities, most of the time no-one knows who the current owner is, not even the supervisor and regulator.
The endless churning of contingent claims, including derivatives, when the purchaser has no identifiable insurable interest, turns financial intermediation into a market-mediated betting shop. Then the betting slips become bearer securities and are themselves traded, either OTC or on organised exchanges, and the derivative transactions volumes expand to dwarf the transactions in the markets for the underlying financial claims (let alone the markets for the underlying real resources). At that point, the betting tip of the financial tail of the real economy dog does all the wagging. It does not create value but redistributes it in a way that consumes real resources and exposes the real economy to unnecessary risk. It’s time to tame the tiger.
 Tobin, James , “On the Efficiency of the Financial System”, Fred Hirsch Memorial Lecture, New York, Lloyds Bank Review, No. 153, July, pp. 1-15, reprinted in Tobin , Policies for Prosperity; Essays in a Keynesian Mode, Edited by Peter M. Jackson, Wheatsheaf Books, Brighton, Sussex. pp. 282-296.