How should derivatives be regulated?

To begin to answer this question, we must first understand the role of derivatives. Most derivatives serve two roles. They provide a means for insuring against specific risks. In such cases, they should be treated as insurance products and be regulated in a manner similar to other forms of insurance. They also provide a means to gamble. In such cases, taxation might be more important than regulation.

Let’s consider crude oil futures. These derivatives are traded on organized exchanges such as the New York Mercantile Exchange (NYMEX), and enable investors to commit to buying or selling 1,000 U.S. barrels of light, sweet crude oil per contract at specific prices at future points in time. Transportation companies, such as airlines, face an oil price risk since their fuel costs tend to move in line with crude oil prices. To hedge or insure against future fuel price increases, airlines can buy crude oil futures whereby they can lock in the future price of crude oil.

Producers of crude oil face the opposite price risk to that of transportation companies. To hedge or insure against the possibility of lower future oil prices, producers of crude oil can sell future contracts to lock in guaranteed prices. So there are both buyers and sellers of crude oil futures who are hedging against different price risks. For both groups, these derivatives provide a means to insure against price risks, and so their transactions in the futures market should be treated as a form of insurance.

There also are speculators who buy or sell oil futures to place bets on the future direction of oil prices. Speculators are just gamblers, and like gamblers they do not play a useful economic role. However, it has been argued that speculators make derivatives markets more liquid and hence less costly for those parties who rely on them to insure against specific risks. Liquidity has value. But what is the optimal level of speculation for liquidity purposes? In other words, when is there too much gambling in a derivatives market?

Now let’s consider the case of credit default swaps (CDS). These derivatives provide buyers of bonds and other forms of debt a means for insuring against credit (default) risks. The buyers of such financial assets are paid a premium to insure against such risks. But CDS offer additional insurance. Thus, investors who buy a bond also can buy CDS in case the interest rate premium they receive is deemed to be too low given their credit risk expectations. (Obviously this raises the question: why would they have accepted too low a premium in the first place? In trying to answer this question, we begin to see the absurdity of CDS.)

Anyone who sells CDS to investors in debt instruments is providing them an insurance product. There also are speculators who buy or sell CDS as a means to bet on credit risks. This group of participants in this derivatives market do not invest in the underlying debt instruments. They are just gambling on the future direction of credit risks.

Derivatives which are used for insurance purposes should be treated and regulated as insurance products. A good starting point for regulation is to require that all such derivatives be traded on organized exchanges. Furthermore, the rules NYMEX has in place for oil futures (trading unit, minimum price fluctuations, maximum daily price fluctuation, last trading day, delivery period, alternate delivery procedure, position limits, and margin requirements/reserves) can serve as a starting point for regulating other derivatives markets.

Derivatives which are traded by speculators for gambling purposes should be subject to a transactions tax (Tobin tax). To further discourage gambling in derivatives, all profits should be treated as taxable income and be subject to full taxation – no capital gains taxation; and no losses should be permitted as write-offs against taxable income.

Of course, there is the problem of drawing the line between speculators and hedgers. I would put the onus on all participants in derivatives markets to identify themselves and prove that they are hedgers, not speculators.

PS: I am heading West for the next week, so my blog will return on Valentine’s Day.

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.