September 25th, 2008

Are derivatives a boon or a menace? A year ago Ben Bernanke was defending financial innovation (h/t Kevin Drum):

The dispersion of risk more broadly across the financial system has, thus far, increased the resilience of the system and the economy to shocks.

Somehow I don’t have quite the same confidence in establishment economists as I used to. So although I barely know more about this than John McCain, I’ll see how far I can get on my tod from common sense.

Physics tells us that any electromagnetic field creates clouds of virtual pairs of particles. Positrons and electrons spring into life and promptly annihilate each other. Derivative contracts and other bets are similar. They are created out of nothing, and die on their maturity. There is no obvious natural limit to their number.

I’ll start with a real example. Two weeks ago I took a flutter on Barack Obama’s carrying North Carolina, thinking odds of 5 to 1 against were attractive. My unknown counterparty, Mr Wrong (surely this a boy’s game) bought the other side of the contract. Here’s our position on 16 September on the Intrade contract “Obama carries North Carolina”:


A couple of things to note about this creation.

First, it has a real economic cost – it’s not a zero-sum game. We both had to deposit margin ($32 in total), and forgo the yield on a more sensible use. The interest on the margin deposits is one way Intrade makes its money. The contract burdens us with the opportunity cost of the tied-up capital.

Two: will Mr Wrong pay up when I win? Will I pay up if I lose? Intrade doesn’t appear to guarantee settlement other than by the margin requirement. The two sides of the contract, the two financial virtual particles, now have separate legal existences, so either of us can sell on our half. I have have no idea who the current Mr. Wrong may be. I do know however that some Intrade traders are crazy manipulators. The main point is that between us, we have created a counterparty risk that wasn’t in the universe before.

Now move on to today. Obama has had some excellent polls in the state, so the price has moved up. Hooray! Update the table:


Intrade may make a margin call on Mr Wrong, since his losses exceed his initial margin deposit. They may release some of my margin, but I’m not going to do anything with it. The economic cost has gone up. (I could balance the margins by making another bet, but that also increases the total economic cost.) What’s more, Mr Wrong and I face an uncertainty about our margins that wasn’t there in the pre-bet universe. We have created volatility.

There’s yet another factor. Intrade’s margin calculation depends on the existence of an ongoing market. That isn’t assured. There a still a few offers (but no trades) against sure things like McCain carrying Alabama: I can’t think why – are they for real? Suppose a hurricane strikes Charlotte tomorrow. Among the least important effects would be a suspension of opinion polling. The evidential basis for the political betting would disappear, and quite possibly the existence of a contract price. Our little bet assumes and expands a preexisting systemic informational risk.

To sum up, Mr Wrong and I have created out of nothing four deadweight burdens:

* the opportunity cost of tying up our capital,

* the volatility of this capital requirement,

* counterparty risk,

* a systemic informational risk.

These costs are inconsequential for Intrade. But they certainly are not for the gigantic markets in financial derivatives: the total size of the credit derivatives market is $62 trillion. So the deadweight burdens are large.

The equivalent of Intrade’s margin requirement for banks is the reserves that they have to set aside to cover the risks in their derivative positions. The banks lobbied hard to allow these to be calculated with their own in-house models – this laxity will have to go. The total amount of capital tied up, even at current inadequate ratios, must be in the tens of billions. These capital requirements are also, as noted above, inherently more volatile; so banks become more dependent on each other to meet their regulatory obligations. What brought the house down however was the systemic informational risk; the subprime mortgage derivatives couldn’t be priced.

Derivatives are claimed by apologists to be a Good Thing, making markets work more efficiently. Standard Victorian examples are trotted out – the corn futures that allow farmers to finance their planting, kerosene futures that allow airlines to hedge against oil price swings, currency futures that help exporters. These are used as poster children to justify the much bigger markets in stuff for which no such case has been made: stock index future options, credit default swaps . The approach of banking regulators to derivatives, expressed in the recommendations of the Basel central bankers’ club, has been to require reserves against derivatives but not to control which derivatives exist.

I think that has to change. Any derivative market creates deadweight costs. The presumption must be that it’s as socially worthless as Intrade (footnote). Any financial institution with access to the lender of last resort – and that now includes pretty much all of them – should have to justify in detail how each of its clever toys benefits the real economy.


It’s been claimed that political betting markets provide useful information and not just an enjoyable casino. I don’t get this; all that bettors have to go on is the same polls everybody can see. They are basically poll aggregators, and Nate Silver does it better.

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