Derivative trading regulations
I have to admit, this article covers a topic about which I know very little. I suppose you could say
I am looking for someone to educate me on the subject. Have you ever heard of derivative trading? I didn’t have a clue what it was until sometime last year. You know, when all things financial and economical went somewhere very hot in a hand basket? Thanks to some very informative articles from NPR and my own research, it was easy to see this practice was a big part of the cause of the financial crisis our country is now in.
Just to make sure everyone knows what derivative trading is, here is the definition from Wikipedia.
A derivative is a financial instrument that is derived from some other asset, index, event, value or condition (known as the underlying asset). Rather than trade or exchange the underlying asset itself, derivative traders enter into an agreement to exchange cash or assets over time based on the underlying asset. A simple example is a futures contract: an agreement to exchange the underlying asset at a future date.
Does that make it clearer to you? If it doesn’t, there’s no need to feel lonely, as I am in the same boat. Actually, I do understand it, to a certain degree, but not nearly as well as I want to. As the definition mentions, the futures market is a simple example and if it had stayed that simple, then I doubt there would have been a problem. The trouble is, it hasn’t stayed simple. Again, from Wikipedia:
Derivatives can be used by investors to speculate and to make a profit if the value of the underlying moves the way they expect (e.g. moves in a given direction, stays in or out of a specified range, reaches a certain level). Alternatively, traders can use derivatives to hedge or mitigate risk in the underlying, by entering into a derivative contract whose value moves in the opposite direction to their underlying position and cancels part or all of it out.
If I understand the last quote correctly, traders (speculators, maybe?) can use derivatives to gamble on the way a certain product will move in the market. You can either make a lot of money or lose your shirt, depending on how good of a guesser you are. All of this without actually owning the original asset.
You may ask, how did all of this come into play with the current financial crisis? It’s simple, really. The general public began to realize there was major trouble when Lehman Brothers went under and when American International Group (AIG) nearly followed in their footsteps. The financial troubles both companies suffered can be traced back to the companies they insured through credit default swaps, which is a form of highly speculative derivative trading. Simply put, they bet the barn and it burned down with them in it. The illustration to the left explains it even better. The only reason AIG stayed afloat is because of the billions of dollars the American taxpayer kindly provided.
Now to the reason I am writing this article. The House of Representatives is currently considering H.R. 4173, which will be the most sweeping rewriting of financial regulations since FDR. First, a question. Is there anyone who does not believe something needs to be done to prevent this same thing from happening again? Considering the magnitude of the crisis, I seriously doubt it.
At the heart of H.R. 4173 is the creation of a new government entity, the Consumer Financial Protection Agency. President Obama and Barney Frank are both big fans of this new agency, but I have not decided if I support it or not. I have to wonder if our federal government is already big enough. When the left and the right hands can’t get together, that may be too large. There is an amendment that will kill the new agency, with a vote scheduled today.
Concerning another part of the legislation, there was a vote yesterday that stripped some of the regulations dealing with derivative trading from the bill. Nearly half of the Democrats and all of the Republicans voted to scale back the regulations. From The Associated Press:
The legislation still imposes restrictions on derivatives, aiming to prevent manipulation in and bring transparency to a $600 trillion global market. An amendment by New York Democrat Scott Murphy, adopted 304-124 Thursday night, exempted businesses that trade in derivatives, not as financial speculators, but to hedge against market fluctuations such as currency rates or gasoline prices. The amendment also provided an exception for businesses that are not considered too big to be a risk to the financial system.
As a conservative, I do not believe the federal government should be involved in our lives any more than necessary. Having said that, I have to wonder at the Republican support for this amendment. It’s clear that derivative trading was at the very heart of the financial crisis we are currently in, along with mortgage backed securities that were based on bad loans. Is this not a problem that should be dealt with? Maybe the scaled back proposals will be enough and that’s why I said I wanted someone to educate me. I certainly hope so because I would hate to be on the same side as Barney Frank on anything.
There is one more thing to consider. Just a simple question, about the real root of the problem. Can any government entity regulate the greed that led to derivative trading being used this way? At the very least, it’s something to ponder.
Good job Larry. Derivatives markets were originally designed to help individuals and businesses manage risk. If a farmer thought the price of corn might fall before he was able to bring his crop to market he could go to the futures market and sell corn futures to lock in his selling price. If a mutual fund manager was concerned that the price of IBM stock might fall but he didn’t want to sell it in case he was wrong, he could buy a put option to protect him against the drop but allow him to participate if the price went up. The farmer and the mutual fund manager are legitimate users of derivatives for hedging purposes and they are the users the amendment seeks to exempt. This makes sense as long as the definitons are written VERY clearly so pure speculators, who buy and sell derivatives simply to make money, cannot get around the restrictions. Someone needs to monitor that closely — a government overseer is required though it can be part of some existing acronym instead of creating a new one.
Thanks, Mike. I understand it better now. My main concern is that the regulations will not go far enough and leave the door wide open for something like this to happen again. That’s why I questioned Republican support of the amendment that would scale back the regulations. I will be okay with that, as long as it does not scale it back to the point of making it useless.
You’ve got my head spinning Larry. I know something of futures trading and thats about it. I think the big boys in these markets are not gamblers, but have access to information the man in the street know nothing of. Yep I think the futures market is rigged along with derivative trading with a few having the inside track and the rest just flipping the coin. I’ve little use for speculators who in reality are not real speculators—they contribute nothing, produce nothing but money which in the end is not eatable or wearable, but merely a tool in their hand to screw others. And as for regulators, well they are the worst of the bunch with no clue as to what is happening with their only interest being drawing their next paycheck from the luckless taxpayer who in the end get screwed by both sides. Thats life Larry, one is either the screwer or the screwie!!!!!
Ron Russell´s last blog ..General Patton and the War on Terror
LOL!! I didn’t mean to make you dizzy, Ron. I guess my rambling excuse for an article was my way of wrapping my head around derivative trading and the upcoming regulations.
It wasn’t the derivatives as much as the underlying assets. A derivative is only as bad as the asset it is derived from. If those horrible real estate loans had never been made for instance, the speculation would not have been there, those mortgages would never have been bundled into the disastrous derivatives, Fannie and Freddie would never have backed those bad loans that opened the derivative floodgates for these mortgages, and companies like Lehman and AIG would never have bought these things, or in the case of AIG, offering credit default swaps; basically covering these derivatives in case they crashed (and they sure did).
That’s my pre-school analysis. It’s actually quite complicated.
rjjrdq´s last blog ..Illegal Aliens Hammered In California
Pretty good analysis, if you ask me. Much simpler than my long, drawn-out ramblings.
In the case of AIG I think it was the credit default swaps on Lehman Brothers stock that broke the bank. Lehman had issued an enormous amount of debt and many of the buyers also purchased credit default swaps to protect themselves in case Lehman ran into trouble. AIG sold billions of dollars of those Lehman CDSs and did nothing to hedge themselves against the risk of a Lehman default. Oops!