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Derivatives and gambling

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Derivatives and gambling

For the benefit of U.S. Senators Dodd, Corker and Shelby; Governors King (Bank of England) and Carney (Bank of Canada); and Presidents Sarkozy and Obama:

In a previous blog I discussed how derivatives play two roles – as a form of insurance against specific types of risk; and as a means to gamble. I also discussed how derivatives which are used for insurance purposes should be regulated. Furthermore, I recommended that derivatives which are used for gambling should be subject to a transactions tax to make trading in such derivatives less attractive; and be taxed in such a way to increase the after-tax costs and risks for gamblers. Derivatives used for gambling serve no useful economic function!

I suspect that policy makers do not understand derivatives and how they are used, and as a result, defer to the self-serving warnings of the financial industry to minimize government intervention in the functioning of derivatives markets. It is long overdue for policy makers to develop some expertise in finance and particularly in derivatives. If the policy makers in Brussels had some experience in these areas, Greece would not have been able to mask the securitization of airport fees and lottery revenues as non-debt transactions.

If the esteemed senators, governors and presidents do not agree with my description of the role of derivatives and the value destruction of derivatives used for gambling, then perhaps they might take a close look at a very recent blog written by Neil Unmack for Breakingviews.com, part of the Thomson Reuters empire.

The title of Mr. Unmack’s blog is “A primer on credit default swaps.” I now quote from the subsection entitled “Who trades sovereign CDS?” (I have added the emphasis in the following.)

“Long-term investors in government bonds, such as pension funds or central banks, aren’t the main users, although they perhaps should be. In theory, they could use CDS to hedge positions, or to invest more efficiently by selling protection instead of just buying government debt. Banks use sovereign CDS to hedge parts of their business that may be generally exposed to a particular country. But the common wisdom is the main users of sovereign CDS are hedge funds and proprietary trading desks betting on CDS prices.”

So the main users of sovereign CDS, just one of many different types of derivatives, are gamblers!

Hedge funds are financial intermediaries. They attract savings to invest in various types of financial assets. Do we really want financial intermediaries to gamble with the money they attract from savers? (This is in essence what many savings and loan companies did in the U.S. in the 1980s with disastrous results.) Does gambling make our financial markets more efficient?

I leave it to the senators, governors and presidents to answer these questions. I have already provided my answers.

The opinions expressed in this blog are personal and do not reflect the views of either Global Brief or the Glendon School of Public and International Affairs.


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