Know Your Options

New at Reason: Gene Callahan and Greg Kaza take a call on widely scapegoated, barely understood derivatives.

Comments

[Alex]

The problem isn't so much the use of derivatives per se, but the use of them to skirt accounting and capital adequacy rules. Like using a swap to mimic the terms of a bond without technically having to issue one (or declare the loan.) Accountancy is chartered to discover such shenanigans, but the accountants are often the deal drivers in structured finance and other deriv-intensive spheres of banking.

Another thing is suitability -- what natural exposures correspond to any of the funkier deriv. products out there (including most classes of options), or are they invented to throw off the scent of clueless auditors (and investors?)

Investors should demand complete transparency -- detailed VAR- and credit-at-risk-based accountancy for ALL derivative exposures on ALL public financial statements, including the parameters used to describe these measures. Sunlight as always is the best disinfectant.

[Alex]

Re: Enron -- profitable though they may have been, much of Enron's profit derived from high variability prop. trading, involving VAR amounts many times larger than that reported on their annual report. Also, m-t-m adjustments in long dated illiquid instruments permitted "p/l smoothing", making their earnings appear more regular to the public than was appropriate. "hedge accounting" rules kept all this stuff invisible.

[Brad S]

Derivatives, used properly, can be used to hedge away many kinds of market risk.

Derivatives, used improperly, can be used to further leverage an already risky position.

In a way, derivatives are like motorcycles. They are not overly dangerous in-and-of themselves, but they can certainly be used dangerously.

[Jason Ligon]

Brad's got it.

I cringe when people blame the instrument for this or that negative result. For some reason, I am skeptical that the critics would be willing to shoulder the increased risk in investing overall that would inevitably be the result of a 'clamp down' on such 'dangerous' investments. Rather, we would just hear about how risky markets are and that smart investors should stick to government bonds or some such. Ick.

[Ron Hardin]

Derivatives are a tempting way to recoup a loss you can't afford, when you have nothing else to lose owing to impending bankruptcy. So they're a moral risk to that extent, like S&L loan guarantees.

You get failed transactions, and if the loss is too big, the derivative exchange can't eat the loss and make it good for the traders. So you get a chain of failures in what should have been sensible trades for most parties.

I suppose what ought to happen is that the exchange needs more capital; but I don't see how to get that much.