Regulating Derivatives is Futile

A funny story of unintentional hypocrisy in the WSJ:

“I don’t trade on margin”–Rep. Spencer Bachus (R., Ala.) who made roughly four dozen trades in shares of ProShares UltraShort QQQ and its options

“Representing Las Vegas, let me assure you, no casino on the planet behaves as irresponsibly and recklessly as Wall Street does”–Rep. Shelley Berkley (D., Nev.), had 57 trades in 2008 in levered, short, ETFs.

“[We must] rein in excessive risk and leverage in the pursuit of short-term profits.”‘–New York Democratic Sen. Kirsten Gillibrand, whose husband made more than 250 transactions in options in his E*Trade account in 2008.

As Lewis Carrol noted in his wonderful books, the meaning of words can be ambiguous, leading to all sorts of confusion and chicanery. The word ‘derivative’, for example, applies most to synthetic CDOs, but also to options, which theoretically applies to equity, which is an option on a firm where the strike price is the face value of the debt. If that makes no sense to you, then you should not be too excited about financial regulation, because as soon as you regulate certain securities, its spirit will migrate to something else you never anticipated

This happens all the time. In the late 1980’s, it was ‘HLTs’ or Highly-Levered-Transactions, that were hot during the junk bond boom. In the internet bubble it was ‘equity-based financing’–the equity of the firm was the collateral. In the latest, it was ‘innovative underwritiing standards’. It’s all leverage in a different product area.

So now, while congress is debating new restrictions on what investors can do, they should note that all sorts of securities are set up to go up N times as much as some reference index or security, where N could be negative. For example, ProShares offers equities targeted towards going short in factors of 1, 2 even 3 times the index.

In a growing economy, you can’t prevent speculation while allowing innovation; the wheat and the chaff are intrinsically linked, separated primarily by hindsight, as when Michael Lewis notes the obviously prescient home mortgage short-sellers in his #1 Book The Big Short. If you pass a law against X, there will be a natural inclination to re-label such action via different vehicles that obtain the same results.

It is well known that excessive leverage is a distinguishing characteristic of financial crises; it is less well known that this is not an aggregate property, but rather, concentrated in different sectors and products each time, which is why economists can not predict business cycles. So note that whatever is specified in this new financial reform bill, will just be relabeled and continue, benefiting securities lawyers and other middle men like Goldman Sachs who are good at this game.

Ultimately, the only thing dampening excess is the rational foresight of investors, who generally get what they ask for good and hard. To the extent a certain activity recently caused a great deal of grief, you can be pretty sure that it will be safe for the next generation. That is, the great stability after the Great Depression was not from New Deal legislation, but its affect on the conservatism of investors in response to that crisis. All this financial regulation in the pipeline are classic hindsight fixes that just add fixed costs, as irrational and hubristic as any levered CDO.

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About Eric Falkenstein 136 Articles

Eric Falkenstein is an economist who specializes in quantitative issues in finance: risk management, long/short equity investing, default modeling, etc.

Eric received his Ph.D. in Economics from Northwestern University , 1994 and his B.A. in Economics from Washington University in St. Louis, 1987

He is the author of the 2009 book Finding Alpha.

Visit: Eric Falkenstein's Website

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