I posted the following to the Cantor Exchange forum a couple of weeks ago. That same weekend, this piece by Zach Karabell appeared. We make some of the same points that are relevant in a generally hostile environment towards derivatives and markets.
Rich Jaycobs’- expertise and realism on issues such as insider trading and manipulation are invaluable to the Cantor Exchange project, especially given the backdrop of the failure of the financial system. A letter from Max Keiser to the FT and related comments underline the challenge of knee-jerk public reaction to innovative contracts.
This is a typical reaction: “-I can’-t believe this. The financial mess we’-re in right now is, in a very large way, due to this kind of crap …- it’-s simply gambling.”- These sorts of claims need to be dealt with.
First, the contracts that are being proposed are traded on exchanges. As many, including myself and the CFTC have argued, lack of transparency in pricing was one of the main culprits of the financial meltdown. The surest way to deliver a shock, a high standard deviation move, to markets is to just not mark or otherwise mis-mark prices for a while. Without active trading, risk build-ups. Explosion and collapse follows.
Leverage also played a significant role in the crises. After all, without leverage, the bogeyman of derivatives is largely defused. Of course no CFTC-regulated contract, most of which allow for substantial leverage, has yet defaulted.
Nor would the proposed contracts suffer from the specific agency problems that infected credit markets and investment houses, so I’-m not sure what “-kind of crap”- the commenter had in mind precisely. It is meaningless that the box-office contracts happen to be “-derivatives”-.
Max Keiser does propose a specific problem. What if a studio blows-up in the box-office market, forcing it into bankruptcy? This line of thinking quickly becomes absurd. If society were strictly bound to “-do no harm”-, nothing would ever get done. Even doctors do harm in the form of side-effects. They evaluate courses of action in terms of the expected net result and so should we in these cases.
Over time, the net benefit of well-regulated markets will be positive, but realism is needed to stand up to these essentially prudent concerns. It does seem to be the case, for example, that commodity futures exhibit structural influences on prices that are independent of usage-based supply and demand, and that may increase volatility. Whether that is more attributable to the existence of the contract or ultimately fiat money is debatable, but in any case, this should be much less of an issue in markets like the box-office contracts, which are settled objectively in a relatively short period of time. In contrast, the exact “-meaning”- of a perpetuity or commodity future is not clear.
We can imagine self-fulfilling prophesies and other possible side-effects, and of course there are some issues we aren’-t thinking of, but the supporters of innovative contracts have to be on top of the foreseeable pathologies and engage critics in terms of specifics. Generic anti-market, anti-derivative carping is not an argument.
And remember that the eve of the French Revolution, no-one would have predicted Emperor Napoleon.
Yes, Napoleon later “-blew up”-!