I got a chuckle from this article in the Economist: (Link)
For several years I have been pushing against all of the voices saying that it was essential that financial derivatives be banned or that their use be dramatically curtailed. It isn’t that I think that derivatives are such a great thing. I do believe they contributed to the 2008 blowup. The problem is that they are so much a part of the system that to change their role and function would, undoubtedly, cause a bunch of bad things to happen.
Most derivative contracts are related to credit and debt. The reason there is so many derivative contracts is that there is so much debt. The CIA put total world cross border debt at $69 Trillion for 2011:
The Economist puts total derivatives outstanding at $700 Trillion, so for every $1 of global GDP there is $10 of derivatives. This sounds crazy, but is not inconsistent with other markets. Global forex trading is running at 50 times global trade and the turnover in stocks is 20 times asset values. That derivatives are 10 to 1 versus global debt should not be much of a surprise.
That the capital markets must churn multiples of actual underlying values is understandable. An individual transaction causes a transfer of risk from one party to another. The subsequent transactions are the market mechanism in which risk is transferred through the system and ultimately absorbed. Why it takes so many knock on transactions to achieve the necessary transfer of risk is a mystery to me. It just does.
In the back of their minds, the regulators know that putting constraints on markets will result in something breaking down someplace else. The deciders know that the most likely place for a breakdown to occur is the global market for sovereign debt. Without a relatively smooth running market for the massive amount of sovereign debt, the economies would come to a violent halt. The deciders and their regulators may understand this, but they also want red meat when it comes to derivatives.
With the critical importance of derivatives in mind, the regulators and other deciders have taken the path of least resistance. They want to “fix” the problems with derivatives by forcing these evil contracts to settle through central clearinghouses. And that is exactly what is being done.
One of the big pushers of the Central Clearinghouse ‘resolution’ to derivatives was none other than our pal Tim Geithner. He had this to say on June 11, 2011:
Without international consensus, the broader cause of central clearing will be undermined.
Tim and the other deciders got their way (mandatory central clearing is required under Dodd-Frank). But a new systemic risk is the consequence of their efforts. The Clearing Houses have now become ground zero for risk. Some thoughts from the Economist on the Clearing Houses that Geithner etal. have been pushing for:
It THEY failed, there would be “mayhem”.
Paul Tucker of the Bank of England.
“If you put all your eggs in one basket, you better watch that basket.”
Ben Bernanke (quoting Pudd’nhead, a Mark Twain character).
“Too big to fail, on steroids”
Regulators and deciders need to “do things”. When they do things, they can stand up to a big audience and say:
“We did something to fix a big problem. Now re-elect us to do more good work!”
Actually, what the regulators have done is concentrate risk. Exactly the opposite of what the markets are attempting to do. The regulators are trying to unscramble the eggs and put the diversified risks back into the original shell.
I understand why people are uneasy with financial derivatives. A lot of folks think of derivatives in the same way they think of necrophilia; despicable and obscene. I can’t offer a truly valid explanation of why it takes $600 Trillion of them to spread the risks of a $70 Trillion economy. And yes, I’m afraid of them.
But I’m also afraid of what happens when the use of them is constrained. This is not a free lunch. Derivatives are an essential component of the capital markets, like it or not. The “solution” patched together by the regulators has not made the world safer, it has just magnified the risk in one or two places. It would not take a failure of one of the Clearing Houses to bring about a catastrophic end. Merely the whisper of a problem would do it.
To the regulators who are cheering their success, I would respond with:
You just magnified the risk!
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