This article is from the source 'bbc' and was first published or seen on . It will not be checked again for changes.
You can find the current article at its original source at http://news.bbc.co.uk/go/rss/-/1/hi/business/8428315.stm
The article has changed 3 times. There is an RSS feed of changes available.
| Version 0 | Version 1 |
|---|---|
| Viewpoint: Derivatives alone don't wreck markets | Viewpoint: Derivatives alone don't wreck markets |
| (about 14 hours later) | |
| By Robert Reoch Fund manager | |
| Consider for a moment the analysis of a hypothetical motorway pile-up. | Consider for a moment the analysis of a hypothetical motorway pile-up. |
| Who is to blame for the financial car-crash in the markets? | Who is to blame for the financial car-crash in the markets? |
| Investigation revealed that the accident started when the driver of a sports car lost control on an elevated section. | Investigation revealed that the accident started when the driver of a sports car lost control on an elevated section. |
| The car had, in fact, been modified by the dealer so that it could go faster than the manufacturer originally intended. | The car had, in fact, been modified by the dealer so that it could go faster than the manufacturer originally intended. |
| This modification had the seal of approval from a motoring authority and the car salesperson had explained the implications of the modification to the driver. | This modification had the seal of approval from a motoring authority and the car salesperson had explained the implications of the modification to the driver. |
| But it was uncertain as to whether the explanation was satisfactory, whether the driver was listening, cared or even understood. | But it was uncertain as to whether the explanation was satisfactory, whether the driver was listening, cared or even understood. |
| Further investigation of the crash revealed that the construction of the elevated section did not conform to road safety guidelines, while a recent snow fall had not been cleared by the council. | Further investigation of the crash revealed that the construction of the elevated section did not conform to road safety guidelines, while a recent snow fall had not been cleared by the council. |
| Furthermore, on the day in question, there was an unusual amount of other sports cars on the same section of road and this probably encouraged faster driving. | Furthermore, on the day in question, there was an unusual amount of other sports cars on the same section of road and this probably encouraged faster driving. |
| To agree on who to blame for the crash would be difficult. Initial blame would probably be directed towards the sports car driver, but with time, would be directed elsewhere, as the crash was triggered and exacerbated by a combination of factors. | To agree on who to blame for the crash would be difficult. Initial blame would probably be directed towards the sports car driver, but with time, would be directed elsewhere, as the crash was triggered and exacerbated by a combination of factors. |
| Car-crash economics | Car-crash economics |
| Shift gears for a moment and consider what has been going on in the financial markets - and specifically, the derivatives markets over the last two decades. | Shift gears for a moment and consider what has been going on in the financial markets - and specifically, the derivatives markets over the last two decades. |
| For sports car modifier, read bank financial structurer. For car salesperson, read bank salesperson. For motoring authority, read credit rating agency. | For sports car modifier, read bank financial structurer. For car salesperson, read bank salesperson. For motoring authority, read credit rating agency. |
| For council, read financial regulator - and for the non-existent authority that could have predicted the unusual amount of cars on the road and introduced temporary speed restrictions, read central bank or a possible future systemic risk regulator. | For council, read financial regulator - and for the non-existent authority that could have predicted the unusual amount of cars on the road and introduced temporary speed restrictions, read central bank or a possible future systemic risk regulator. |
| Anybody with a mortgage, car loan or un-cleared credit or store card balance contributed to a mountain of debt that was unsustainable | Anybody with a mortgage, car loan or un-cleared credit or store card balance contributed to a mountain of debt that was unsustainable |
| In the 1980s, the world's larger banks started to exchange financial risk - that is the risk that currency or interest rates might change or that a borrower may default on a debt obligation - using an array of products called derivatives. | In the 1980s, the world's larger banks started to exchange financial risk - that is the risk that currency or interest rates might change or that a borrower may default on a debt obligation - using an array of products called derivatives. |
| For every user reducing risk, there was another user investing in that risk, and by the early 2000s, a new generation of investors had embraced derivatives - and they had the seal of approval from rating agencies, regulators and central banks. | For every user reducing risk, there was another user investing in that risk, and by the early 2000s, a new generation of investors had embraced derivatives - and they had the seal of approval from rating agencies, regulators and central banks. |
| Derivatives quickly permeated most of the more traditional financial markets, culminating in complex products that can, for example, provide risk participations in pools of sub-prime mortgages. | Derivatives quickly permeated most of the more traditional financial markets, culminating in complex products that can, for example, provide risk participations in pools of sub-prime mortgages. |
| But they also spawned very simple products that enable home-owners to put an upper limit on their mortgage rate - or tourists who buy foreign currency for their holiday to fix the rate for selling back any spare currency at the end of their travels. | But they also spawned very simple products that enable home-owners to put an upper limit on their mortgage rate - or tourists who buy foreign currency for their holiday to fix the rate for selling back any spare currency at the end of their travels. |
| Financial engineering | Financial engineering |
| Throughout this evolution, the underlying vehicle - the derivative - remained similar in form to early incarnations, just as the modern sports car shares features with the first mass-produced car, the Ford Model T. | Throughout this evolution, the underlying vehicle - the derivative - remained similar in form to early incarnations, just as the modern sports car shares features with the first mass-produced car, the Ford Model T. |
| But just as the introduction of safety features in the auto sector and better roads allowed cars to be driven faster, so, too, did enhancements to the functionality of banking and derivatives, combined with light regulation, enable the creation of more complex financial products. | But just as the introduction of safety features in the auto sector and better roads allowed cars to be driven faster, so, too, did enhancements to the functionality of banking and derivatives, combined with light regulation, enable the creation of more complex financial products. |
| But whilst the crash analysis found little blame with the sports car manufacturer or indeed with Henry Ford, in response to the financial crisis, most of the criticism has been directed at the banking sector and the derivatives market. | But whilst the crash analysis found little blame with the sports car manufacturer or indeed with Henry Ford, in response to the financial crisis, most of the criticism has been directed at the banking sector and the derivatives market. |
| Complex financial products are blamed for bringing down insurer AIG | Complex financial products are blamed for bringing down insurer AIG |
| Elsewhere, as with the car crash, those responsible for regulating or rating the movement of risk have come under the spotlight. | Elsewhere, as with the car crash, those responsible for regulating or rating the movement of risk have come under the spotlight. |
| But somewhere on the list is us - the consumer. Anybody with a mortgage, car loan or un-cleared credit or store card balance contributed to a mountain of debt that was unsustainable. | But somewhere on the list is us - the consumer. Anybody with a mortgage, car loan or un-cleared credit or store card balance contributed to a mountain of debt that was unsustainable. |
| The consumer was the beginning of a complex production line where everybody appeared to benefit. Consumer loans were packaged and sold to banks who repackaged them and sold them on. | The consumer was the beginning of a complex production line where everybody appeared to benefit. Consumer loans were packaged and sold to banks who repackaged them and sold them on. |
| Intermediaries appeared to add value by providing an independent perspective on the riskiness of these increasingly complex investments. | Intermediaries appeared to add value by providing an independent perspective on the riskiness of these increasingly complex investments. |
| Regulators smiled on the diversification of risk around the world. | Regulators smiled on the diversification of risk around the world. |
| And at the end of the line, investors gobbled them up because the returns looked good, given the apparent risk which, as with the crash analogy, was not well explained, understood or, in some cases, even considered. | And at the end of the line, investors gobbled them up because the returns looked good, given the apparent risk which, as with the crash analogy, was not well explained, understood or, in some cases, even considered. |
| As cash poured into the financial markets from North Asia and the Middle East, the demand for these investments grew. And with that, so did the demand for consumer loans leading to plentiful and cheap consumer credit. | As cash poured into the financial markets from North Asia and the Middle East, the demand for these investments grew. And with that, so did the demand for consumer loans leading to plentiful and cheap consumer credit. |
| This process nourished two decades of "buy now, pay later" and pushed savings in the West to nearly 0% of take-home pay. | This process nourished two decades of "buy now, pay later" and pushed savings in the West to nearly 0% of take-home pay. |
| Counting the cost | Counting the cost |
| As this mountain of debt unbundles, so, too, will much of the machinery that enabled its growth. Some have argued that complex financial engineering ultimately added no value to the financial sector's main role - the mobilisation of cash from those who have it to those who need it. | As this mountain of debt unbundles, so, too, will much of the machinery that enabled its growth. Some have argued that complex financial engineering ultimately added no value to the financial sector's main role - the mobilisation of cash from those who have it to those who need it. |
| Professor Benjamin Friedman from Harvard University has analysed the cost and benefits of the financial sector in the United States. | Professor Benjamin Friedman from Harvard University has analysed the cost and benefits of the financial sector in the United States. |
| Controlling the flow of capital to a growing global economy must go beyond just regulating banks and derivatives | Controlling the flow of capital to a growing global economy must go beyond just regulating banks and derivatives |
| Part of his research reveals that in the early 1950s, the finance sector accounted for 3% of all US salaries. In the current decade, that share is 7%. | Part of his research reveals that in the early 1950s, the finance sector accounted for 3% of all US salaries. In the current decade, that share is 7%. |
| From the 1950s to the 1980s, the finance sector in the US accounted for 10% of all profits earned by US companies. In the first half of this decade, it reached a staggering 34%. | From the 1950s to the 1980s, the finance sector in the US accounted for 10% of all profits earned by US companies. In the first half of this decade, it reached a staggering 34%. |
| These wages, profits, office costs etc are all parts of the cost of running the system that moves capital. The higher this cost, the lower the overall benefit to the economy. | These wages, profits, office costs etc are all parts of the cost of running the system that moves capital. The higher this cost, the lower the overall benefit to the economy. |
| I suspect that such an analysis outside the US would reveal similar results and it therefore should come as no surprise that bank regulators around the world are contemplating many changes to the financial sector. | I suspect that such an analysis outside the US would reveal similar results and it therefore should come as no surprise that bank regulators around the world are contemplating many changes to the financial sector. |
| But just as reducing road accidents requires a combination of limiting the driver as well as improving the infrastructure, controlling the flow of capital to a growing global economy must go beyond just regulating banks and derivatives. | But just as reducing road accidents requires a combination of limiting the driver as well as improving the infrastructure, controlling the flow of capital to a growing global economy must go beyond just regulating banks and derivatives. |
| As somebody who helped develop parts of the derivatives market in the early 1990s, I am sad that products designed for bona-fide risk management purposes were used for such speculative purposes. | As somebody who helped develop parts of the derivatives market in the early 1990s, I am sad that products designed for bona-fide risk management purposes were used for such speculative purposes. |
| But I am also worried that the political and regulatory response will constrain all usage rather than bad usage: effectively banning the car rather than restricting bad driving. | But I am also worried that the political and regulatory response will constrain all usage rather than bad usage: effectively banning the car rather than restricting bad driving. |
| When George Soros - the well-known market speculator - benefited from Britain's exit from the ERM, or a rogue Chinese banker lost a fortune trading copper, or more recently when oil was driven to dizzy heights due perhaps to speculation, criticism, concern and censure were directed at the users, not the underlying financial instruments. | When George Soros - the well-known market speculator - benefited from Britain's exit from the ERM, or a rogue Chinese banker lost a fortune trading copper, or more recently when oil was driven to dizzy heights due perhaps to speculation, criticism, concern and censure were directed at the users, not the underlying financial instruments. |
| The same should apply to banks and derivatives: as with so many things in life, accidents are mainly caused by the driver, not the vehicle. | The same should apply to banks and derivatives: as with so many things in life, accidents are mainly caused by the driver, not the vehicle. |