8 May 2018

What are they doing on Wall Street?

Olivia writes:*
"Financial operations do not lend themselves to innovation." -- John Kenneth Galbraith
You may have heard of the term credit default swap (CDS) before. These financial contracts were often mentioned in the aftermath of the global financial crisis. CDSs formed the bulk of toxic assets held by the financial institutions who required government bailouts in order to avert a global economic catastrophe. But what are derivatives really? What purpose do they serve? What value, if any, do they create?

The notional value of the global derivatives market was estimated to be $542 trillion in June 2017. For comparative purposes, the world GDP was approximately $76 trillion in 2016. There seems to be a strange tension between the apparent importance of this market, at least in terms of size, and the general lack of understanding or concern for what is being exchanged when people trade over-the-counter (OTC) derivatives. A simple definition of a derivative is “a security whose value is determined by, or derived from, the value of an underlying asset.” This definition raises more questions than it answers.

The main types of derivatives are swaps, futures, forward contracts, and options. Without going into detail about each type of derivative, they can be understood by their function.

Derivatives are essentially bets, and their purported function is the hedging of risk. How derivatives can be used to hedge risk can be understood using the example of the financial crisis: banks were giving out mortgages to people with high default risk and, using CDSs, the same banks were able hedge risk by purchasing insurance against default (or betting on the default of the mortgages they were issuing). The possibility to insure against default incentivised people to increase the rate at which they issued sub-prime mortgages, and simultaneously, people were incentivised to bet on the default of these mortgages.

The fundamental issue with derivatives is that the party to a derivative does not necessarily need to have an insurable interest in the underlying asset, meaning that the banks issuing the mortgages were not the only ones betting on the default of the underlying assets, the mortgages issued by the banks. This issue brings us to the second real function of a bet: pure speculation. Derivatives allow people to speculate on assets in which they have no proprietary interest, meaning that the derivatives market through the churning of contingent claims can turn financial intermediation into a “market-mediated betting shop”, as described by Willem Buiter, the chief economist at Citigroup. There are serious macro-economic risks to such a practice as incentives can easily become distorted, and it is unclear whether the reforms implemented at the end of the financial crisis were sufficient to avert another crisis of the sort.

In the case of CDSs, the distortion of incentives refers to the fact that banks were willing to issue mortgages to people who were very likely to default, because the insurance provided by derivatives guaranteed a return on investment regardless. Beyond this, there were people who had no insurable interest in the mortgages they purchase insurance for and are therefore primarily motivated by the default of mortgages.

It is hard to see how derivatives are an economically productive instrument in this context. The use of derivatives matters for economic growth and development because, while derivatives may seem detached from the real economy, the fact that they are securities whose value is derived from real underlying assets, and that anyone can be part to a derivative transaction, means that derivatives, rather than being simply a means to hedge risk, can be a source of additional macro-economic risk.

The cost of this risk is not confined to the holders of derivatives, as shown in the 2008 financial crisis. When companies are invested in volatile financial instruments, or have stakes in companies invested in volatile financial instruments, the volatility of financial markets can surface in the real economy, as it did during the financial crisis. Furthermore, the institutions that profited from the misuse of complex high-risk financial instruments were not the ones to bear the final cost, as illustrated by the $85 billion bailout of AIG.

At the end of the day, it is taxpayer money that went towards maintaining the institutions which were only too eager to pursue risky investments in hopes of high-returns. Not only does this bailout set a dangerous precedent (is this the path of economic development we want to take?), but it also leaves the instruments that enabled this greed to take such dangerous proportions largely unchecked. These instruments were dubbed “financial weapons of mass destruction” by Warren Buffett in 2002 [pdf] because of their opacity. They are hard to value and hard to regulate, but if derivatives are to be allowed, regulation is imperative to avert the risk of further macro-economic instability (especially in a global economy in which contagion can rapidly occur).

On the positive side, the 2008 crisis resulted in a completely unregulated market becoming slightly regulated through the Dodd-Frank Act and the European Market Infrastructure Regulation, which are a baby steps in the right direction. The question of whether derivatives cause more harm than good does not seem to have a straightforward answer, but it would be better if we found out soon through better regulatory oversight and regulatory evaluation, rather than going through a repeat of 2008.

Bottom line: Derivatives can easily be misused and this poses serious macro-economic risk. What is going on in Wall Street can affect the real economy in serious ways, and recognising the potential for macro-economic instability is important. More fundamentally, it is unclear whether derivatives are necessary for an efficient financial system and global economy. Clarity will emerge from determining when derivatives are an unnecessary source of volatility and economic harm, and when they serve their initial purpose, by providing the opportunity for investors to hedge risk and enabling additional financial stability.

* Please help my growth and development economics students by commenting on unclear analysis, other perspectives, data sources, etc. (Or you can just say something nice :)