Sense on Cents

Derivatives….where does one even start? Can you touch it? How do you know when you’ve seen one? What does it look like? Is it edible?

The fact is, we have derivatives throughout our economy. From consumer products, to medications, to new technologies, one could make the case that almost all new developments are derivatives in one way, shape or form.

Wall Street developed financial derivatives under the guise of mitigating risk. Regrettably, the guile and greed of those on Wall Street abused the development of derivatives and many of these financial instruments were not risk mitigants, but risk propellants. Let’s navigate the derivatives landscape and see why Wall Street will not cede this turf without a fight.

The base products on Wall Street include government securities, agency securities, mortgage-backed securities, corporate bonds, municipal securities, short term bonds, emerging market bonds, foreign currencies, convertible bonds, preferred stock, and common equities.  Each of these “cash” products is a large market in and of itself. That said, the “wizards on Wall Street” connected to each of these product lines have manufactured products “derived” from the cash flows of the underlying “cash” product. Welcome to the world of derivatives.

When properly used, derivatives – much like new, approved medications – can be amazingly helpful in augmenting returns and managing risk. However, not unlike “designer drugs,” the abuse of these financial instruments can be deadly. Wall Street has made enormous sums of money across the board on these “medications.”

Now we learn that under the Obama financial regulatory reforms, derivatives will be traded on an exchange and thus monitored much more closely. This is a good thing, right? Please focus very carefully on this point because this is where Wall Street has largely already won the derivatives battle.

“Standardized” derivatives will be traded on an exchange. “Customized” derivatives, much like prescription drugs or designer drugs, will not trade on an exchange. Why is this such an important point?

Products traded on an exchange have total transparency and limited profitability. Products traded away from an exchange have much wider bid-ask spreads, much greater profitability, much greater risks, and much greater likelihood for abuse. The Wall Street lobbying machine has already been fighting this battle in Washington and winning it.

Financial derivatives can be amazingly beneficial if properly used. That said, even legal and prescribed medications can be deadly when abused. The cops on the Wall Street beat will remain seriously challenged to monitor those “designing,” “marketing,” and “selling” the “customized derivatives.”

LD

This entry was posted on Thursday, June 18th, 2009 at 8:38 AM and is filed under derivatives, General. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.