Regulating Derivatives: After SEC vs. Goldman Sachs, Can You Keep Them Down on the Farm?

Whether and how to regulate the financial institutions’ creation and trading of exotic derivatives? Who should be enabled, or barred? Are there some so complex or toxic they should be banned? And critically – who thinks that Senator Dodd and his cohorts in the US Congress can sort it out?

I go back to the lessons on the farms of my youth.

It was an unvarying ritual: every evening, when the chores were done, my grandparents would convene to listen to the market reports, over the bakelite Philco that had pride of place on the kitchen table.   

It was especially important, when their feeder calves were ready for market, to have the daily cattle prices from the stockyards of Chicago and Omaha and Sioux City – because their timing had to strike a delicate balance. A driver and his truck had to be engaged. But commit to ship too early, and the animals would be under-prepared. Yet the risk of delay, for possible price moves, meant the possibility of being wrong, plus the dual impacts of extra feed costs and a loss of quality due to over-finishing.

By the time I was old enough to spell “cattle futures,” my astute grandfather was, through his commodities broker, hedging the on-the-hoof financial exposures that were out fattening in his feedlot – mitigating the random forces not only of market volatility but also pasturage and herd diseases and freight costs and all the malign hazards of a family farm.

What of his counter-parties? On the other side of his trades may have been Iowa Beef or McDonalds, or more likely a pure speculator – the zero-sum nature of derivatives trading made no difference to him.

The derivatives markets have known forever that at the end of the chain, some end user converts pork bellies to bacon and Brent crude to aviation fuel and even some of the gold into jewelry. But it doesn’t care. Grandpa’s fatted calves wound up as steaks and roasts and hamburgers, but trading regimes have never limited derivatives participation to packing houses and restaurant chains. Rather, a multitude of positions have evolved by way of options and futures, longs and shorts, insurance and hedges. 

And it’s equally true throughout the financial markets, where product innovation is one of capitalism’s articles of faith. Equity ownership in a single company begat the assembly of portfolios -- in turn democratized into managed mutual funds. From which it was no long step to the massively popular index funds, and thence to tradeable positions on the indices themselves.

Wagers of all varieties became available, on the movement of the S&P 500 or the FTSE 100, or sub-indices sliced and diced to the customized needs of the players big enough to ask. And the model is not only very far removed from actual ownership in the original underlying stocks – it bears considerable resemblance to the concoction by Goldman Sachs of a shortable product only distantly related to the houses temporarily occupied, before foreclosure, by the original subprime borrowers.  

Society has similarly concluded that the only requirement to sit at a gaming table is a stack of chips. The house will happily offer a chance to play, and to accept the money of the unsuccessful, without requiring proof of aptitude, or a working knowledge of the odds of filling an inside straight or bringing home an exotic roll of the dice.

Such dark pools of manipulated information as dog tracks and jai alai are allowed, for the entertainment of the tourists and the fleecing of the credulous. And local governments themselves peddle lottery tickets to the masses, against odds that would make a card shark blush.

In his hard-shell Methodism, Grandpa would never have set foot in a casino – he’d have scorned the frivolity and, more to the point, would have shunned an activity so far out of his capacity to comprehend and manage.

But allowed to live under his own principles, he’d have given taciturn tolerance to those engaged in legal if obtuse gambles.

Raised on the working end of a plowline and a pitchfork, and through a life driving a tractor and pitching bales of hay, Grandpa cultivated understatement and restraint -- along with an annual abundance of corn, beans and beef -- and never used two words when one sufficed.

His snort of derision would have been a wordless editorial -- “fool, to play a game you don’t understand.” But his own hard work and intelligent self-reliance would have respected the inevitability of creative innovation.

Rather than let a bunch of posturing politicians dictate or constrain his investment choices, he’d have let the markets decide which financial products proved their value, measured his risks, and taken his own advantage.

And so should we. 

 

Thanks for joining this dialog. Please share with friends and colleagues. And if not a subscriber, you are invited to sign on at the Main page.

 

 

 

Comments

[David Albrecht]

Nice post, and very pleasant to read.

I don't know that Dodd could understand it, but I could.

Dave

[WDF]

And Grandpa would have been mightily peeved if he found that the markets were speaking out of both sides of their mouths I suspect.

[Henry]

I thinks the problem here is not Grandpa options but investors trading with mutual funds or other saving accounts trying to get a double deck surplus and slice their commission without measuring the risks involved. Those have to be banned in gambling, it`s not their money. Gambling should be for individuals or group of them in knowledge they are gambling and not only investing. This option could reduce market volumes, but certainly Brent crude will not go up to 150 and paid by car owners.