Time To Hate On Derivatives?

David Frum thinks there ought to be less opposition to derivatives regulation. The real problem with financial regulation, he argues, is the creation of the Consumer Financial Protection Agency. As Reason's Katherine Mangu-Ward has frequently noted, there's plenty to dislike about the CFPA. But do derivatives—financial products in which the value is pegged to another variable—make a good bad guy? I'm not so sure.

Derivatives are often described as bets, and that's not inaccurate. But without context, that terminology can give the impression that using derivatives is the Wall Street equivalent of a drunken Las Vegas dice game. But in many instances, the truth looks a lot less like playing a wild casino game and lot more like adjusting cells inside a spreadsheet.

The first thing to remember is that, despite derivatives' reputation for causing chaos, they have, for decades (at least), helped a variety of basic, boring businesses—from farming to airlines—safely manage their risk. Here's a simple example from the Congressional Research Service:

A firm can protect itself against increases in the price of a commodity that it uses in production by entering into a derivative contract that will gain value if the price of the commodity rises. A notable instance of this type of hedging strategy was Southwest Airlines' derivatives position that allowed it to buy jet fuel at a low fixed price in 2008 when energy prices reached record highs. When used to hedge risk, derivatives can protect businesses (and sometimes their customers as well) from unfavorable price shocks.

The benefits of this kind of risk management, which allows businesses to lock in prices for crucial resources in volatile markets, are widely recognized, even by derivatives scaremongers. Warren Buffett, for example, has referred to derivatives as "financial weapons of mass destruction," but he is invested in them to the tune of about $63 billion through Berkshire Hathaway. (Which explains why he called for a regulatory exemption on the derivatives he already owns.)

More broadly, derivatives can be used to speed up the identification large-scale risk—and perhaps even the "systemic risk" that's been the subject of so much recent debate. This is when they start looking a little more like bets. One type of derivative known as a credit default swap is essentially an informed wager that a firm or investment will default on its obligations. The side benefit here is that, because informed individuals are putting money on their guesses, they can serve as prediction markets.

And those predictions could be used to ring warning bells about the state of the financial system. In the most recent issue of National Affairs, Harvard's Oliver Hart and the University of Chicago's Luigi Zingales proposed using CDS prices as early warning signals to let us know when big financial firms may be nearing failure.

If one had to predict in August 2007 the five institutions that would go under first on the basis of their CDS rates, one would be correct in four out of five cases. By the end of 2007, the data showed a decisive worsening of the situations of the investment banks and Washington Mutual. In late December, the market put the probability of Washington Mutual's defaulting within a year at 10%. By March 2008, that estimate had risen to 30%—and yet the regulator waited until September 25 to take over the bank.

Derivatives can be quite complex, but it's easy to see how they can serve as checks on the market. As Gordon Crovitz wrote yesterday, "Reducing the opportunity for traders to take advantage of better information means slowing the pace at which better information enters the market." Derivatives, in other words, give us more information, and thus hasten price discovery. There are certainly risks involved in using them, but, in general, the more restrictions we place on their use, the less we're likely to know about what's actually going on in the market.

In 2004, Gene Callahan and Greg Kaza wrote in defense of derivatives.