Derivatives, more particularly credit derivatives, were at the heart of the crisis that overwhelmed financial markets in 2007 and triggered the worst-ever global recession. Yet, efforts to regulate these rather complex financial instruments have met with fierce resistance from bankers. The Frank-Dodd Act is essentially toothless, as it prescribes no methodology for regulators to use for such regulation. Nor has the Act made it mandatory to clear all derivative trades through a clearinghouse where exposure and risk could be monitored by regulators. Four years after the worst-ever financial crisis, we are still without effective regulation of credit derivatives.
Eric A Posner and E Glen Weyl, at the University of Chicago, have published a seminal paper on the need for, and methodology of, regulation of financial derivatives: Applying the Insurable Interest Doctrine to Twenty-First-Century Financial Markets. The paper is available for download at http://www.law.uchicago.edu/Lawecon/index.html and is very readable without any complicated mathematics and/or jargon. Invoking the principle of 'Insurable interest', it sets out a universally valid test to segregate hedging from gambling or speculation in financial transactions. The principle was first invoked in Britain in early 19th century to curb gambling by the general populace by taking out life insurance policies on the lives of politicians even when they had no direct interest in the outcome. The principle saved the life insurance industry from the infamy of gamblers. Might such a principle save the derivatives market from itself?
The bankers' efforts to keep the credit derivatives out of clearinghouses, and the purview of regulators, are understandable. Due to deposit insurance, and the reluctance of governments to let banks fail, the credit risk in banks is effectively transferred on to governments, and from there, to tax-payers. Bank depositors, the main stakeholders in banks, have no incentive to monitor a bank's risk exposure and little expertise in doing so. This sets up an incentive for banks to load up on risk without attracting additional equity capital. Unregulated credit derivatives offer unprecedented leverage. In the absence of a central clearinghouse, exposure to them cannot be monitored. Bankers therefore find them ideal instruments to put on risk without having to raise matching capital. The bankers' lobby is therefore fighting tooth and nail to avoid any regulation in this area.
Numerical illiteracy has played a crucial role in the history of finance. Moneylenders used the intricacy of the compound interest formula to enslave labour for centuries. Governments have had to ban usury, and slave labour, but the practice surfaces every now and then in disguised forms. Some of the credit card products are little short of enslavement. Derivatives, and credit derivatives in particular, carry on the hoary tradition of mesmerisation of the masses with abstruse mathematics of stochastic equations. Yet the price distributions of the underlying asset on which Black-Scholes, and all other valuation models depend, assume random walk. As any trader will testify, markets as constituted could hardly function if prices were truly randomly dispersed around a mean. The result is that even without any rigging, most models grossly underestimate tail risk and are overwhelmed by black swan events.
It is, therefore, truly remarkable that Posner and Weyl have been able to cut through the mathematical clutter to arrive at a set of principles that all can understand. The authors propose: [a] all financial products based on derivatives should be required to demonstrate that their use contributes to overall risk reduction for intended users of the product, and system as a whole; [b] that the products actually play a beneficial role in enhancing the efficiency with which financial markets allocate capital; and [c] that the products confer no inherent advantage to any one group of participants over others in the market. These three criteria, taken together, would eliminate products from the menu that merely permit speculation and add to the overall risk in financial markets by introducing risk for risk's sake. They would not interfere with normal calls, puts, futures and other derivatives in the market that are used by participants in constructing hedging strategies.
The authors have borrowed from the regulatory model for drugs to propose a regulator, such as the SEC, or the FED, who will examine all derivative products before they are introduced in the marketplace. If that sounds draconian, it is not because the measure is unjustified but because the concept is unfamiliar. Warren Buffett described derivatives as weapon of financial mass destruction and events after 2007 proved him right. The authors have fleshed out well-defined criteria for a regulator to use in examining such new products, and in the hands of experts, these should be easy to apply unambiguously. A case can be made to allow product introduction of new products but subject to a mandatory regulatory review in three to six months after they have been in use. Either way, the case for regulation now has a solid conceptual base thanks to the two authors.
The paper has also examined the nine broad categories of derivatives in use ranging from simple futures and options to credit and statistical derivatives with a view to examining the role they play in capital allocation, net contribution to reduction of overall risk in the system and the manner of their use. The examination is rigorous and fair. Clearly, credit derivatives and some statistical derivatives have almost no role to play either in enhancing the efficiency of the capital allocation process or in risk mitigation.
It may be noted that credit derivatives come into play on existing debt instruments and hence do little to ease the manner in which debt is raised in markets. On the other hand, they have been the main conduits used by bankers to inject risk into the system to aid heuristic speculation by holders of traditional debt instruments. Mortgage-based securities could never have been sold in such large quantities to such risk-averse investors such as insurance companies without bankers specifically constructing credit default derivatives that they new would fail in distress.
Financial markets are a mirror to the real economy. They are a consequence of the real economy and have a profound effect on what the real economy does. Speculation is at the heart of the financial markets. No mechanism for price discovery can work without an element of speculation as its basic mechanism. There has always been a realisation that excessive speculation is bad for the markets and results in less than optimal, distorted prices. However, efforts to distinguish between healthy speculation from its price-distorting cousin have proved exceedingly difficult. As a result, the regulatory pendulum has tended to swing from one extreme to the other with changing fortunes in the financial markets. In the process it exaggerates the boom bust cycles inherent in financial markets.
The paper by Posner and Weyl does seminal work in laying out the conceptual basis for distinguishing the good sort of speculation from the bad with a clearly defined set of criterion. An expert regulatory body working with these tools could easily weed out products, which are nothing but vehicles for gambling, while retaining those that contribute towards efficiency in the real economy. The authors have chosen not to focus on the absence of a clearinghouse for all derivatives traded in markets, especially the over-the-counter market, which allows bankers to escape regulatory scrutiny and margining provisions.
That aspect, while relevant to the regulation of derivatives, was clearly not the focus of this paper. Nevertheless, I don't think any regulation of the derivatives market could work without a strong mandatory clearing mechanism that provides raw data on exposure and use to regulators in policing the markets for misuse and containing associated credit, market and other risks. Perhaps the authors themselves would not insist on prior scrutiny of products by regulators if such a clearing mechanism were in place.Posner and Weyl's paper is truly ground-breaking, on par with the Black-Scholes-Merton model that set off the derivatives revolution. What's more, it is easily accessible free of esoteric mathematics. If it reignites interest in derivatives regulation after the Dodd-Frank Act fiasco, so much the better.