Wednesday, October 29, 2008

What's Good About Derivatives

It's enough to give gambling a bad name. While the mere existence of derivatives did not cause the current financial crisis, their misuse had a tremendous impact. The cries for increasing levels of government regulation not only lock the barn after the horse has been stolen, it turns out that the horse was stolen from the stable, not the barn. (By that I mean, more government regulation is not the answer, but a restructuring of the financial system to reinstitute checks and balances that function as part of the system itself, with the government to police abuses — deviations from desired behavior — not force desired behavior.)

Once upon a time derivatives — contracts to deliver a specific asset, good, or service in a particular quantity at a particular price by a certain date — had a useful purpose. They permitted issuers of financial instruments to gauge how much of what to issue and to whom, just as commodity futures helped producers and purchasers lock in a price and quantity, stabilizing prices and guaranteeing a market.

It wasn't long, however, before speculators realized that they could make money buying and selling not the company or the goods and services to which derivatives give a right to purchase, but dealing in the right itself. This separates the actual asset, good, or service to which the right entitles the holder of the contract, from the right to buy or sell it — a separation of ownership from control. Rather than stabilizing prices and guaranteeing quantities for delivery at the proper time, speculating in derivatives has resulted in wild fluctuations in the future (as opposed to the current) price of the asset, good, or service to which the derivatives give a right.

So, is there anything good about derivatives?

Used as originally intended, of course there is. The commodities markets could hardly function without them. Without futures contracts, farmers and other producers would be strapped for cash at critical times and unable to obtain credit to finance operations. This is obvious, and, as the financial system is currently structured, virtually the sole justification for derivatives.

Under a reform of the financial system, however (as in the Capital Homesteading proposal), the wide variety of financial derivatives would serve another useful purpose: to determine the market price of the underlying asset, good, or service, as well as the risk associated with the sale or purchase of that underlying asset, good, or service. Inasmuch as one provision of Capital Homesteading is to replace the "universal collateralization requirement" of financial institutions with insurance, a solid risk assessment of every conceivable investment is an absolute necessity.

Let the gamblers and speculators have their fun — but include the rest of us out. If someone has the accumulated savings to risk, he or she should be free to speculate, gamble, purchase luxuries, increase consumption, build pyramids, or anything else he or she desires. The one caveat, however, is that at no time should money ever be created or credit extended to engage in this activity. Derivatives do not, in and of themselves, generate income, and therefore cannot be regarded as meeting the requirements for "qualified paper" for which money can be created and credit extended without the necessity of first accumulating savings.

By gambling in this way, the rich will provide a valuable service for the economy, in addition to giving themselves all the thrills and excitement they want. Further, anyone who wants to engage in that activity should be allowed to do so on the same terms: sufficient accumulated wealth to enter the casino, and agreement to abide by the basic rule to use your own money, not someone else's.

Donations to CESJ are tax deductible in the United States under IRC § 501(c)(3):

No comments: