What to do with derivatives

This post is prompted by a corridor conversation today among accounting academics about the role of derivatives in the global financial crisis (GFC). The only thing we agreed upon was that we could not agree.

One of the more strident views expressed was that derivatives are evil and should be suppressed. I think this is too strong. I consider that derivatives are like guns and cars: extremely useful tools in the hands of careful operators but incredibly dangerous in the hands of irresponsible or unskilled users. To continue the simile, in the same way that we try to develop laws to keep guns and cars away from the unskilled and the reckless, we need laws to do the same for derivatives. Despite these laws, we still find guns and cars being used dangerously and I think we will find the same with derivatives - no matter how we legislate we will be unable to stop all abuses. The problem is to find that balance between sufficient regulation to prevent unbearable abuses but not so much regulation to inhibit their use for functions in which they are useful.

The regulation issues with derivatives are twofold: how to regulate the market and how to market participants disclose their exposure to derivatives to investors. These issues are much easier to address with exchange-traded derivatives than with over-the-counter (OTC) derivatives. In this diatribe, I will make the case for exchange-traded derivatives.

Exchange-traded derivatives are easier to regulate as there is a long history of financial market regulation which can (and has) been applied to derivatives markets to ensure they operate fairly. Further advantages of exchange-traded derivatives include:

• the marketability of contracts they generate allowing participants to close-out an open position immediately,
• the use of a clearing house to eliminate (effectively) counter-party risk, and
• the use of margin calls to prevent the development of large uncovered liabilities by participants.

Accounting for exchange-traded derivatives is also easier. As they are traded in a public market, the market value of the contracts can be observed and reported. As the terms of the contracts are publicly available, users are in a better position to assess the risks if the type of derivative is disclosed in the financial reports.

In contrast, OTC derivatives are harder to regulate as there does not have to be any central co-ordination for them. The customisation of OTC contracts make them harder to close-out by taking an opposite position. The lack of a clearing house increases counter-party risk (a major concern during the current GFC), and the possible lack of margin calls allows the accumulation of large uncovered liability positions on open contracts. As OTC exchanges occur in private, it may not be possible to observe and report market values. Finally, as the content of the contracts varies, it is more difficult for users to assess the risks associated with the contract.

These differences between OTC and exchange-traded derivatives provide an argument for differential regulation. This differential regulation can be used to encourage firms to use exchange-traded derivatives and to avoid OTC contracts. Such differential regulation is likely to lead to an expansion on the range of derivatives offered on financial markets but that would not be a bad outcome if there was a corresponding fall in the use of OTC derivatives.