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Peter Crabb: Don't shoot the derivatives messenger

Don’t shoot! It’s just the messenger. One of the messengers in the financial markets is taking the blame for a poor economy.

Policymakers are forging ahead with new rules for trading in the exotic financial contracts known as derivatives. Derivative markets are seen by many as no more than financial casinos, but this is not their primary function.

A derivative is any financial contract where the price depends upon (is derived from) some other asset. The derivative contract itself has no independent value. The price of the transaction is determined by changes in the value of the underlying asset, which can include stocks, bonds, commodities, currencies, or mortgages.

Many Idaho companies use derivatives to protect against risk. For example, Micron uses derivatives to hedge its risk of changes in the value of foreign currencies.

According to Micron’s most recent financial reports, the company is exposed to risks in the change of the Singapore dollar, euro and yen. Management is taking an active strategy to protect against these risks. The report states: “The Company uses derivative instruments to manage exposures to foreign currency. The Company’s primary objective in holding these derivatives is to reduce the volatility of earnings associated with changes in foreign currency.”

On Tuesday this week, the chairman the U.S. Commodity Futures Trading Commission called for stronger rules on swaps, a specific type of derivative widely used to hedge risks in the bond and currency markets.

While derivative markets can be used to speculate, they serve other very important function as well, such as price discovery. This is the process whereby investors, speculators, and hedgers alike determine the most probable, or expected, price and value in the future.

Derivative markets are messengers — they provide information.

Restricting trade on derivatives will reduce trading in the underlying asset because less information is available. Without an independent assessment of a particular bond or stock’s risk that comes from the price information in the derivative market, investors will be less willing to hold such assets. With fewer investors, companies will have a harder time raising the capital they need to expand their business and create jobs.

More information is always better — it makes all markets more efficient. If you have good information on the quality of a used car you are considering for purchase you will make a better decision. When information on the car is withheld you may end up owning a the proverbial lemon.

Economists call this situation asymmetric information — where one party to a transaction holds better information then the other party. The risk of loss in this transaction is greater because either the seller or the buyer could potentially take advantage of the other party’s lack of knowledge.

Rather than restricting trade, regulators would be better off just getting more information. One new proposal aims to do just that.

As reported in The New York Times this week, the U.S. Senate is moving forward with a financial system regulatory overhaul bill that would create a new Office of Research and Analysis. This agency, also referred to as the National Institute of Finance, would provide daily research on the well-being of financial institutions, including hedge funds.

The hope is that with more information, regulators will be able to spot bubbles like that seen in housing prices a few years past, and any negative information will motivate preventive actions. Regulators and the markets will be well served by the research this new messenger brings.

They need not, however, close off the derivative markets. Don’t shoot the messengers we already have.

Peter R. Crabb is a professor of finance and economics at Northwest Nazarene University in Nampa. He earned his doctorate in international and financial economics from the University of Oregon.

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