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Using Derivatives ‘Like Hard Drugs’

Posted by Larry Doyle on March 9, 2010 9:16 AM |

Prescription drugs can only be accessed through a physician for a reason.  When used appropriately under the guidance of an ethical and informed doctor, the powers of prescription drugs can be life-changing and life-saving. When these prescription drugs are marketed by those more interested in their own bottom line than the health and well-being of their ‘patients’, then use often turns to abuse and the effects are crippling.

A similar dynamic plays out in the high and mighty halls of international finance. The Financial Times writes a captivating story on how the abuse of derivatives has overwhelmed cities and towns across Italy. This article, entitled An Exposed Position, is a riveting view as to how the abuse of financial derivatives will have untold costs for years to come.

As with any prescription medicine or financial product, the first question a potential buyer/investor needs to ask is whether to trust the ‘doctor.’ Who would knowingly ingest medicines or products if you thought the provider was less than totally ethical? The FT addresses this very point:

The scandal also raises bigger questions about the ethics of the financial industry in relation to complex products. In recent years, most bankers assumed they were allowed to sell anything they wanted to non-retail clients, since it was presumed that “sophisticated” investors would be able to protect their own interests.

However, what has become clear in Italy is that many public sector clients were unable to understand the maths of complex finance risks. This is likely to force investment banks to rethink their definition of “sophisticated” clients; it could also encourage politicians in Europe and elsewhere to clamp down much more aggressively on the entire derivatives trade.

Once again, Caveat Emptor is the order of the day. As the buyers of the products became more ‘hooked,’ the marketing and pricing became that much more aggressive.

The FT highlights this development:

The more complex the deals became the less the local authorities understood them, claim several lawsuits against the banks. Derivatives specialists and some political sources dispute this and say local politicians chose to ignore the risks because of the potential gains. Domenico Siniscalco, then finance minister, warned back in 2004 that local authorities were using derivatives “like hard drugs”.

I do not absolve the users of these hard drugs from their responsibilities and obligations. By the same token, not every distributor of the ‘hard drugs’ is necessarily unethical. Very simply, the risks of the derivatives do not come with sufficient transparency. Additionally, what is plainly obvious is that not only in Italy but literally everywhere around the globe, the pushers and distributors of these ‘hard drugs’ are not properly regulated. Why not?

All too often we see that the regulators are in bed with the pushers.

Who bears the ultimate costs? Society, that is the taxpayers of the towns, cities and states, not only in Italy but in every other country where these hard drugs have established a foothold.

What a world.

LD

  • coe

    Here’s my take on this – first, for the record, both interest rate and credit derivatives have clear beneficial properties when applied prudently..the problems cropped up for two core reasons in my opinion – the off-balance sheet nature of the contracts contributed handily to opaque accounting and hid the true “costs” on an ongoing basis; and the purveyors provided for excessive levels of leveraged notional exposure – literally trillions of dollars beyond the on-balance sheet footings of the participants; second, the product growth accelerated and dangerously moved from serving as a hedge of existing balance sheet risk to a levered form of risk-taking in and of itself; third, water seeks its own level – the financial and Treasury folks in the government and municipal offices around the world were simply not adequately conversant in the critical performance aspects of these products; and fourth, the nature of Wall St tends to push the distribution to the weaker links – so when things got a bit more difficult in America, the party moved to Europe and Asia. As we combine these factors with a group of global regulators with disparate accountabilities and plenty of other problems to tackle, in twenty-twenty hindsight they could not and certainly did not get in front of the inevitable financial catastrophe triggered by the derivative tsunami. So we are all in massive clean-up mode.

    I am of the very strong opinion that we shouldn’t throw out the baby with the bath water. I think the comparison to hard drugs is very unfair…derivatives do indeed offer prescriptive value, but as with any medicine, if you swallow the whole bottle, you will overdose!






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