Financial Reform: Free Markets Sustain Your Wealth
Policy makers put the blame for the financial crisis on derivatives. However, too much leverage, not derivatives, is at the heart of every financial crisis. When the bust comes, those with illiquid positions have a liquidity crisis that can quickly morph into a solvency crisis.
Supporting policy makers is hedge-fund-manager-turned-political-activist George Soros; in an editorial in the Financial Times, he argues there’s no economic benefit from derivatives on mortgage-backed securities. George Soros favors allowing an agency, a bureaucrat, to decide which instruments provide economic benefits and which do not. Under such a scenario, we would have to be prepared to forgo many widely used and established derivatives, such as S&P500 futures, which are also a zero sum game.
Banning derivatives is the wrong approach. It should not be the government’s role to ban people from engaging in behavior that may not provide an economic benefit. Indeed, it is not the government’s role to prevent people from making bad investment decisions, either. Rather, governments should focus on preventing any systemic fallout of such bad decisions that will inevitably be made from time to time.
Every hedger requires a speculator to make the hedging possible: a commodity producer interested in hedging his or her costs needs a speculator to take the other side of the trade. If a speculator is banned from using an instrument, they will look for a proxy – just look at Greece: buying insurance on a Greek default is a political hot potato, so hedge funds simply sell the euro as a proxy rather than focusing their speculation specifically on Greece. If we ban speculators from engaging in derivative trading, but allow entities with a “legitimate” need to pursue such trades, we may inadvertently produce more economic harm than good. Another Enron situation springs to mind should such policies be adopted; it will be more cost effective to move trading desks to commercial enterprises, away from Wall Street.
The real problem that must be addressed is the dangers of excessive leverage. The focus needs to be on mark-to-market accounting and providing collateral for leveraged transactions. Mark-to-market accounting forces market participants to employ less leverage because of the risk that the market may go against them during the holding period of their position, even if their bet may be proven right at maturity. Preferably, derivatives should be traded on regulated markets, but that’s simply not always possible or practical. Take the very simple case of an investor expecting income from a foreign currency denominated fixed income security: the forward currency market, an over the counter derivatives markets, is best suited to lock in the currency risk associated with the income at any time before the proceeds are due.
It is naive to think that any set of rules will eliminate greed and unethical behavior from mankind. Greed is part of what drives capitalism; to contain the negative effects of greed, policy makers use laws, regulations and the bully pulpit. By all means, anyone breaking the rules should be prosecuted. But any rules and regulations will be far more effective and constructive when they work with, not against, market forces: a focus on leverage works with market forces; a ban on derivatives does not.
Axel
Axel Merk
Author of Sustainable Wealth – order now.
President and Chief Investment Officer, Merk Investments
