Tag Archives: derivatives

Why regulating banks is so difficult

Of course, the recent credit crisis was caused by politician’s failure to regulate banks. Clearly, if banks had been properly regulated, we would not be in the mess we are in. And yet, even now, very little has been done to introduce new legislation to prevent further crises. What are the politicians playing at?

This is a typical response to the crisis, but not one I find convincing. To see why politicians have so far done almost nothing to alter the regulatory framework of the banking system, you only have to analyse the preceding paragraph closely. Far from being obvious and prescribing a straightforward course of action, the preceding statements contain a number of dubious assumptions. For example, do we really know what is meant by a bank? Defining a bank is no simple matter, as I argue extensively in The Metaphysics of Markets. Regulating by making distinctions between types of institutions (eg banks/non-banks) is only possible if ‘a bank’ can be clearly delineated. Regulating certain activities rather than certain persons or institutions is also rather tricky. With the use of structured products and derivative instruments (in particular those that trade over-the-counter ie directly between institutions rather than on-exchange), almost any type of trade can be replicated synthetically. In such cases, there is a futility in attempts to regulate.
Is this simply a counsel of despair then? Not quite, since effective regulation should be possible if a more considered approach is taken than has hitherto been the case. Simple definitions and characterisations of institutions must be reviewed. The theoretical problem with current legislation must be understood; after all, we do presently have some regulation (contrary to certain commentary). If our existing regulation is inadequate, we must try to see why, before simply tweaking it as we have done time and again in the past in response to other crises.
The apparent lack of political interest in these matters probably reflects an acknowledgement of the prima facie intractability of the issues. But the complexity of the problem at hand is rarely in itself adequate justification for not seeking a solution. And on this score more than any other, politicians certainly stand culpable.

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What are financial derivatives?

A simple, textbook definition of financial derivatives will typically resemble the following:

A derivative is a financial contract, asset or instrument that derives its value from another underlying security.

Typically, derivatives are treated as distinct instruments within financial institutions. Historically, banks have tended to have ‘derivatives desks’ and specialist ‘derivatives traders’.
However, in The Metaphysics of Markets, I question whether this straightforward definition is adequate and likewise whether the segregation of ‘derivatives’ as an asset or security class is appropriate. This is because the fundamental nature of derivatives contracts can be hard to pin down. After all, what about well known cases of futures markets ‘driving’ spot markets? Does this make the relevant underlying contract derivative?
My suspicion is that derivatives instruments are generally misclassified. A better approach is to realise that derivativeness is a property or attribute rather than a class in its own right. And whilst certain commonly-perceived to be derivative instruments such as options contracts exhibit a great deal of derivativeness, this is not the same is simply classing them as derivative instruments simpliciter.
Why does this apparently subtle difference in interpretation matter? It matters because derivatives as currently conceived are thought to be separable. It is thought that derivatives can neatly be isolated in terms of their risk and character and even in terms of their users. But this could well be a false impression. If derivativeness is thought of as a property that many assets can exhibit, this is more than just a change to our current perception. It has profound implications with respect to regulation and risk management for instance.
Derivatives instruments (although this term is formally question-begging in any enquiry into the nature of derivatives) are generally thought to be well defined and understood. However, to my mind, the elementary definition of derivatives that is commonly accepted, is insufficient. This means comprehension of derivatives and their impact is based on a false proposition from the outset. And this is never an optimal starting point.

Read more and buy the book…
The Metaphysics of Markets

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