Avoiding the Tail Wagging the Dog

I’ve written a number of pieces where I have discussed limits on derivatives.  These have seemingly been among my least popular pieces, partly because I seem to argue against the free market.  I’m not arguing against the free market, per se, but arguing that there are some types of contracts that should not be valid on a public policy basis.  This piece is meant to integrate my thoughts on:

  • Having a hard locate with shorting — (shares that have not been previously lent are located and confirmed to be borrowed).
  • Insurable interest with respect to credit default swaps [CDS].  Only hedgers can initiate transactions, and if the hedger sells, he must first collapse the CDS transaction.
  • Insurable interest should apply across all derivative markets, and should become a regular part of insuring systemic stability.  Regulators of the various exchanges would require hedgers to divulge the assets or liabilities in question that they are hedging.  The hedgers would then be allowed to buy and sell contracts up the hedging need, and no more.  Speculators would bid for the right to trade with the hedgers, but could not trade with other speculators.  Every transaction must have a hedger.

One of my core reasons for this is to shrink derivative activity so that it is smaller than the underlying markets.  This will keep “the tail from wagging the dog.”  After all, if you need to do a transaction, why not buy/sell the underlying, on a forward basis if necessary?  Also, let the regulators understand their clients more closely, so that they can better prevent insolvencies.

My second core reason is that speculators dealing with speculators is gambling, and should be regulated that way, because there is no transactional tie to the real economy.  Now, some will say,”Doesn’t all investment involve gambling?”  My answer is no.  All investment involves risk-taking, but there is a difference between risk-taking and gambling.

Every business/businessman takes risks.  Many of those risks get externalized in public security markets because the equity and debt of the company trade on secondary markets.  The prices of the shares and bonds reflect marginal perceived risk of the business.  That risk is necessary risk.  Unnecessary risk is two unrelated parties with no economic interest betting on whether the company can survive or not; such a bet should be regulated as gambling.

Most people buying/shorting a stock have some reason why they think they will make money.  Even if they are wrong, they don’t think their actions are as uncertain as a coin flip.  Few pick tickers randomly, and decide positions (buy/short) randomly.

My third core reason is to reduce regulatory and taxation arbitrage.  Many derivative transactions are done to escape regulations and taxation existing in the underlying markets.  Let these parties abide by the rules of their regulators, and let them pay the taxes that they owe.

There are legitimate reasons for wanting to lay off short-term risk, without selling a long term asset.  But on the whole, speculative markets should not exceed the demand for hedging.  Similarly, markets for shorting should not exceed the amount of underlying available to be borrowed.

That’s my position.  Separate investment and gambling through a requirement of hedging in synthetic transactions.  If some want to gamble on companies, let them go to Vegas; the margin requirments will be tighter.

I know this article won’t be popular, but I do want financial markets to have real legitimacy over the long term.  Gambling, even if legal,  never has moral legitimacy.  Better to have smaller markets that are viewed by most to be legitimate, than to have large markets that have the legitimacy of a casino.