The Answer Is: Derivatives Are Side Bets June 2003 - M.L.M. Do derivatives have something to do with hedging? Do they support the markets? Robert Samuelson answers Yes to both questions. "The markets need speculators to counterbalance hedgers," he writes. ("A Financial 'Time Bomb'?" - Washington Post Weekly Edition, March 17-23.) He isn't alone, of course. Thousands of derivatives traders, not to mention the nation's largest banks, make the same claim. They also make a bundle from investors who believe it. Here's what investors should know. A hedge is a "forward" contract between producers of assets and buyers of the assets. The contract states that the buyer will buy the asset at a specified future date (thus the "forward") and at a specified price. The seller is also bound to make delivery of the asset at the time and price specified. Once the contract is signed, the buyer has a tradable piece of paper, and the market quotes a price for each contract. The price may change, and the contract may trade many times, but it always carries the same terms of delivery date and price for a specified asset. The contract can also be canceled by either the buyer or seller. Either one may pay the other to get out of the contract, if the "spot" or current price of the asset at the time of delivery is very different from the price specified in the contract. So what are derivatives? They are simply side bets on the direction of asset prices. While producers and users are trading contracts for the real assets, speculators are placing side bets on future asset prices. Do these bets support the markets for real contracts? We're not talking markets in small potatoes here. We're talking oceans of wheat or soybeans or oil or interest-bearing bonds or (pardon the expression) pork bellies. We're talking contracts in global commodities, traded among global corporations acting as both producers and users. The real quantities and dollars involved, without any derivatives, create a huge marketplace that makes most stock markets look like, well, small potatoes. However, as investors are repeatedly told, the total value of derivatives is several times the total value of the real assets. Does the volume of derivatives prove that they provide the liquidity lacking in real markets? Hardly. It only proves that side bets are unlimited, like lotto sales. The potential danger, as Samuelson points out, is that the seven largest U.S. banks "account for 96 percent of derivatives holdings." In other words, the banks are the bookmakers, taking bets on either side and trying to balance the bets to limit their own exposure. This doesn't have to become a problem, provided the bookmakers balance their books. But the business is hugely profitable, since the bookmakers take a small commission on every bet, and banks compete fiercely for it. The temptation to let the books get out of balance, in order to keep a bet from going down the street, is always strong. "What can be done?" Samuelson asks. I suggest we start by agreeing to call a spade a spade, a bet a bet, and a bookmaker a bookmaker. If we do, the idea that derivatives bets somehow make the markets function will be seen to be the nonsense that it is. As for the banks, their derivatives business needs to be separated from their banking business. The government may not be able to prevent gambling in asset prices, but it can certainly separate the gamblers and bookmakers from the rest of our financial system and let them succeed or fail on their own. Back to MLM Commentary