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Robert Merton on Regulating Derivatives

January 26, 2010

by Dan Richards

There are two somewhat related criticisms.  One of them is the issue of transparency and the level of risk for an institution, where people at senior levels of management did not fully understand the risks of derivatives.  Secondly, derivatives make it possible to have a degree of leverage that can cause problems.  Are those accurate and fair criticisms? 

They would be fair comments, but as you as intimated by your question, these are tools. They are not tools that, for the most part, are used by ordinary individual investors.  The people who are using these are supposed to be professionals, who are highly qualified and this is what they do in their business.  As I mentioned to you, central banks use them.

We shouldn’t have a picture that this is about poor people who don’t know what they are doing.

That said, there has been misuse. In fact, in regard to the question about senior management, I fully agree that going forward senior managers, boards of financial firms and regulatory overseers have to have financial knowledge of engineering, derivatives and modern technology.  We have to have them knowledgeable enough to be able to properly manage and oversee these instruments.  I think there have been many instances where that knowledge was not present. 

This is not a case of getting rid of tools that are not essential.  You need to make changes.  It’s a little like the head of the Food and Drug Administration or the National Institute of Health saying, “I don’t understand nanotechnology, and therefore we are not going to allow nanotechnology to be used in medicine.”  Any reasonable person would look askance at that and say that’s backwards.  Nanotechnology may not be a good thing for medicine, but the criteria shouldn’t be that because the head of the FDA doesn’t understand them, we shouldn’t use them. 

That’s putting the cart before the horse.  What you really want to say is, “If that’s part of what we need in modern medicine, then regulators better learn to understand it, or we will find someone who does.”

Senior management, and boards in particular, and regulators need to ensure that they have the kind of knowledge necessary to oversee the activity in these markets.  That is critical.

It does not mean that they have to be highly technical people, engineers or PhDs.  But they have to be knowledgeable and trained well enough to understand what these instruments are and the basics of how they operate so that they can ask good questions and demand good analyses.

I fully concur that is likely to be one of the important problems that we need to address going forward.

So you’ve identified the need to create awareness among senior managers and directors.  Are there other lessons that you would take away from the last year and a half going forward?

There are many lessons.

I think that the issue of transparency is very important.  However, it is a word that is overused, and it isn’t always the case that there is no cost to transparency.

Actually, in the derivatives area, there is very high degree of transparency in traded derivatives.  You understand what they are and how they are traded on markets.

Some of the most mundane areas are the least transparent. Ordinary loans by banks – that is very opaque.  Many of the money market operations are actually opaque.  We often treat things that sound very familiar as if they are not a problem, when indeed they are. 

At the same time, we have to recognize that there are a number of structural items that lead to crises, and those items are not caused by either fools or knaves.  It lets us off the hook too easily to say that there were bad people or stupid people, and let’s eliminate them and life will be good. In fact, in many cases even if you had fully ethical, well-behaved individual actions going on, they could still aggregate into systemic risks that cause crises.

If we don’t understand that and accept that, then we miss out on what may be the causes of the next crisis, which eventually we will have, no matter what we do.