Opinions — May 9, 2012 at 4:18 am

Regulating Derivatives: About Time

Hector Franco


Source: thenation.com

 

 

If you are not really all that savvy with the financial news, then you may not think much of this article that was posted a few months ago that gives more regulations on derivates, swaps and futures. Ask the ordinary person on the street about things like that and they will most likely scratch their head and not understand these topics. However, this is not something that people should be ignorant about. Why? Well, if you can follow the news leading up to the current financial crisis and the news after, you will see that derivatives had a lot to do with it. These regulations are only the effect of a culmination of problems that the financial sector has created, all because of greed.

Some Table Setting

Before we delve into the deeper topics at hand, we first have to define the terms. Like how before you can eat dinner, you have to set the table. What exactly are derivatives, swaps and the like and how did they cause the major financial institutions to crash back in 2008 and why they are being regulated more strictly now.

Derivatives, swaps and the like can be defined in this very simple sentence: it is an agreement between two parties wherein they will agree on the exchange of any commodity or asset under given conditions (time, date, price, whatever they agree on).  Put it this way: say you have a barrel of oil in your backyard. You then agree to sell it to your friend six months from now at a price, say A, even though the value of the oil right now is not A. If, at six months from now, the price of the barrel of oil that you have is assessed by the market to be higher than A, your friend saves money because you agreed to sell it to him at that price. However, the flipside will be true if the value of the barrel is lower than A.

When you read it, it does not seem to be all that dangerous. If anything, it allows you to hedge against risk and lends more creativity to financial transactions. Imagine, if you did your due research and you believe that a few months from now, a certain company’s stock price will fall because of this and that. You can buy a derivative from another trader willing to play against that bet. If a few months from now, the price drops as expected, you will gain money because you made the right bet. However, if that does not happen, then you are going to have to just suck up the loss and move on.

The Problem

If you consider the nature of derivatives, it is what some would call “speculative”. It is speculative in nature because you are making decisions now based on the future outcomes of a stock or any asset. If you were a private investor, this would be fine because if you lose out on the bet that you make, then you just have yourself to blame. However, what if you held in your hands millions and millions of dollars then made crappy decisions with your derivatives? This is exactly what happened with the investment banks closing.

The banks got too greedy too fast to make the long story short – the losses they obtained when the derivatives worked against them led to them closing up shop and the government spending an obscene amount of money bailing them out and the crisis still isn’t over – we are still feeling the effects right now.

Regulation

Immediately after the crisis, the government called for stricter regulations. This is the result of those regulations. The U.S. Commodity Futures Trading Commission (CTFC for short) was given the unenviable task of making the final rules, guidance and orders regarding all transactions of this nature that the financial markets will follow or face sanctions.

However, do you think that these regulations will stop banks and other large mutual funds from doing it all over again? There have already been three Basel accords (Basel III is currently in dispute) that give regulations to bank over reserve requirements to guard against these kinds of risks across all the different banks but this crisis still happened.

I think that the problem here is the fact that these investors thought they could get away with selling people bogus derivatives which were rated very highly by the rating agencies but eventually turned out to be junk assets that panned out negatively for them and they did not have enough money to cover all of their losses since all of the people wanted the money that was due them as per the agreement. People could say that no one expected that this would happen in the course of trading but as the other experts said, you can’t really read the market, and you are a fool if you think that knowing some fancy models and equations can tell you better.

The Future

What is the future for this kind of trading? Well, it still is a useful tool. People can use it to leverage against risk if used properly. What these regulations should be focusing on would be a better control over the valuation of these bonds and derivatives so that people will not buy into junk assets ever again. There was really nothing wrong with the system but people manipulated it to death and that is the reason why the world is now in a flux and the old and stable markets suddenly are in a tailspin where they can’t seem to get out as easily as they wanted to. You can’t stop derivatives trading, but you can inject more common sense into it instead of letting greed drive the machine.

What about you? What do you think can be done to regulate it better? Post your suggestions on the comment section below.


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