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Robert Merton on Regulating Derivatives

January 26, 2010

by Dan Richards

Derivatives today have a bit of a tarnished reputation.  No less than Warren Buffett has called them “financial weapons of mass destruction.” Why do they have such a bad name associated with them?

The answer can take several different forms.  Of course, there have been a number of cases of the misuse of derivatives contracts by those who didn’t really fully understand them, and that’s been documented.  There have also been misuses by fools and knaves, who were plentiful.

It also can stem from things you are not familiar with.  We tend to attach a greater fear of risk to something we don’t understand, even if it brings exactly the same amount of risk as something that we are familiar with.

It is also the case that, at some level, everything involves derivatives.  It’s almost reaching the point where you can say “derivatives are involved” and have it apply to any situation.

Derivatives trade either on an open exchange (such as the futures market or options market) or over-the-counter, where they are typically traded by banks or large financial institutions.  The facts are that throughout this crisis, all traded financial futures markets functioned flawlessly.  They functioned better than the cash markets.  In many cases, they were the only markets that were functioning for transferring risk.

If you look at the over-the-counter markets, which have been the ones that had many of the issues, the estimate (although somewhat meaningless) is that the total notional amount of derivatives is between $600 and $700 trillion – a massive number.  Of those, a vast majority were interest rate swaps, which have been used for more than a quarter of a century by banks and others to hedge their interest rate risk.  Those have functioned; I know of no cases where interest rates swaps have raised problems. 

If you look at the derivatives with over-the-counter equities, currencies or commodities, there have been no problems.  When I say “no problems,” I could go further and say that they have been instrumental in allowing the system to continue to function during these very difficult and stressful times.

Where the problems occurred was in one set of derivatives called credit default swaps, which transfer the risk of credit.  They were one of the biggest issues that have been raised. They are also very large and the newest type of derivative.  There were issues certainly, such as with AIG, which was operating credit default swaps.  But the swaps themselves, as far as I know, did not have major problems of default.  The companies that furnished them and were using them had trouble, and we need to make that distinction.

It is important to understand that there is no financial institution in the world, including all the central banks, that can function without using the mathematical computer models of modern finance or without using derivatives.  So the issue is not that these are some side items that are new and fancy and no one understands them and maybe we ought to get rid of them or minimize them.  That is not reality.

The reality is that they are an integral and fundamental part of our system.  What we need to address is what are the issues, what are the problems, and how can we assure ourselves that we will not have those problems repeat themselves.

As is understandable in these types of crises, everyone is both very upset and does not understand everything that is going on, and everyone has found it very costly.  And they want an answer. It would be nice to be able to give one, but in many cases the facts they are working with are not even correct.