About Oil and other derivatives at large… A review of the state of the Art.
I crack up laughing every time I hear an idiot out there stating that derivatives are evil or even dangerous because (a) events associated with derivatives at-large cause pain; (b) pain is symptomatic of a bad thing; (a+b) therefore derivatives, in general, are really bad.
For all the rookies out there, let me just educate you and state some crystal clear facts – at least to set the record straight if not correct the very narrow view of our policymakers – as to how they analyze these instruments from their respective perspectives.
First off, derivatives at large are not evil, nor are they capable of being evil. To claim otherwise is functionally and logically equivalent to claiming guns are evil because people can use guns to commit crimes. People can be evil but, usually, they are just plain stupid – and those people can find vehicles to manifest their intentions/stupidity.
Derivatives are just convenient means of buying or selling insurance. Say if you have an Airline and you are afraid oil is going to bust through $200 per barrel price ceiling because then your company will go bankrupt. An easy means of buying insurance to your company is to purchase some crude oil $200 call options for a very cheap price, i.e., you are buying the right to purchase oil at the price of $200 regardless of what the price will be.
In fact, futures and options are derivatives, but I don’t hear anyone complaining about them being evil or dangerous. The reason why is that they are exchange-traded and have safeguards and regulations that non-exchange traded derivatives like Credit Default Swaps don’t have.
So folks and for all the rookies out there including our Congress people – who have by the way no clue of what they are talking about – , derivatives are neither good nor bad; they simply are contractual agreements between two willing market participants that allow one party to sell exposure to specific risks and the other to gain exposure to the same risks, all in a relatively low-cost manner. Some investors use them to hedge exposures that would otherwise pose too much risk to their primary lines of business (e.g., hog farmers buying pork belly futures to lock in future prices); others use them to neutralize systemic portfolio risks, while still others use them primarily to place speculative bets based on their own views of future economic prospects… but in the end, all of these derivatives are just mutually agreed-upon contracts, and it seems illogical to deem such a contract to be inherently “evil” or “dangerous”.
It is the misuse of derivatives by people that cause pain, not derivatives themselves.
Most of the great catastrophes in finance are usually associated with persons who displayed massive ego/pride/hubris coupled with unhealthy greed and a reluctance to admit wrongdoing.
Look at some of the major disasters: LTCM, Kerviel, Leeson, Metallgesellschaft, Orange County, Mortgage Crisis, S&L Crisis, Madoff. The perpetrators all exhibited – amongst others – these similar base character qualities:
• They had little awareness of the limits of their own knowledge,
• There was an element of pride: either posturing to come across as knowing more / having greater expertise than they actually did, or – with manifest expertise – having contempt for those who questioned their wisdom.
• A deep fear of failure coupled with an inability to admit wrongdoing.
It is a fact that derivatives get a bad rep because they allow leverage – and therein lies the rub.
In almost all cases of severe losses via derivatives, the trader was usually structuring a bet such that they were taking a small – but highly certain – amount of money up front, with a correspondingly tiny risk of absolute catastrophe further down the line. Such decisions were usually made on the basis of “X has never moved a certain amount, so our risk of it going against us is negligible”.
In many cases, the traders went months or years making these bets successfully, creating a nice little feedback loop for their behavior. However, rare events being, by definition, rare means we know very little about them, how to predict them, or how to model their impact. Empirically, these rare events occur far more frequently than any statistical distribution would admit.
So, the inevitable occurred. The rare event eventually came along and wiped them out…if it was a pure “equity” type investment, the losses would have been contained – but derivatives have a couple of features which – when taking certain classes of position – accelerate losses.
I concede that derivative usage is not binary – we don’t just care about whether, on balance, their individual use is “good” or “bad”. We care about the magnitude of the collective outcomes of each. Yet, even on that metric, I think the dollar / social value of all forms of derivative use outweigh the bad (outcomes that were primarily, specifically and significantly related to the use of derivatives).
To conclude, I strongly believe in Free Markets and financial innovation…But there are certain derivatives that should be illegal because they are so incredibly dangerous.
Credit Default Swaps are, in my opinion, the most dangerous derivatives because of the potential for another AIG to occur: large highly rated company sells a massive quantity of swaps in one direction thinking they will never have to pay any claims and then suddenly a “six sigma event” occurs. That company goes down and has the potential to take the financial system with it.
Can it happen again? Of course, it can… AIG sold CDS contracts on sub-prime mortgage CDOs. What is to stop a large European bank from selling massive amounts of CDS on Italian sovereign debt under the assumption that Italy can never default? What about selling CDS in Germany, whose default is unthinkable? The lesson markets teach us is that anything is possible, and when highly unlikely events occur, you don’t want to have several tons of TNT beneath the foundations of your most important financial institutions. That makes absolutely no sense.
Just study AIG carefully and decide whether you think certain types of derivatives should be legal. Try to balance that against my intellectual arguments in here. Is it really worth even a small chance of systemic collapse so people can hedge their bond exposure (or speculate on bonds they don’t own)? 15 years ago CDS did not exist and the world was fine.
I hope this sheds some light and sets the record straight.
Share your thoughts.