Bad Boys Running Wild
In the case of derivatives, their impressive winning streak (in the form of unparalleled growth and innovation) has not received unquestionable amounts of praise or generated uncontested support. In fact, for the past fifteen years or so derivatives have been subject to constant attacks from many different influential pulpits. Journalists, regulators, hedge fund managers, legendary investors, and former investment bankers have all launched fierce attacks on the derivatives industry, accusing its products of being “tools of the devil”, “equivalent to crack cocaine”, and “financial weapons of mass destruction”. Bizzarely enough, the fiercest attacks have coincided with periods of incredible creativity and growth, such as the exotic options revolution in the early and mid-1990s or the credit derivatives boom of the early 2000s. Whatever happened to “everybody loves a winner”?.
Derivatives are despised by so many because so many have experienced losses, sometimes huge losses, through the use of derivatives. Of course, it is true that people also routinely lose their shirts in the cash markets (bond, stock, currency) and yet no one has asked for the banning of bonds, stocks, or currencies. What makes derivatives losses special is that they can be extremely large and extremely sudden (because of the leverage factor), and that the causes for the losses can seem deeply mysterious (because of the complex payout formulas of many products). And derivatives losses have a tendency to hit the headlines in force. Hurting entities tend to loudly blame somebody else, loudly call derivatives disrespectful names, fire senior executives, and sue the counterparty, alleging that they were misled into inappropriate transactions.
By now, we are all familiar with the names that are relentlessly voiced when trying to find reasons to attack derivatives: Metallgesellschaft, Procter&Gamble, Gibson Greetings, Orange County, Barings Bank, Sumitomo, NatWest Markets, LTCM, All-First Financial, Amaranth. All of these institutions lost very large amounts of money because of their dealings with derivatives. They all occupied the front pages for many days. They all gave observers plenty of reasons to develop an unfriendly view of derivatives. They all generated toxic publicity for the industry.
Derivatives insiders have mostly suffered in silence, concentrating more on devicing ever more sophisticated tools and on making ever larger amounts of money than on engaging in a public square debate as to the merits of the products. Derivatives lobbyists have also focused their attention on other matters, such as making sure that politicians do not mess with the cherished self-regulated aspect of the industry. Some people argue that what derivatives professionals need to do is borrow from the pro-gun folks and aggresively spread the message that “derivatives don´t kill people, people kill people”. The idea here is that derivatives per se are not the problem, but rather the way in which they are used. Improperly employed, they can unquestionably cause lots of damage. Properly used, they should be Ok.
The problem with this line of thought is that it is unnecessarily complicated. Who gets to decide on what a proper use of derivatives entails? In any case, and just like with the gun issue, nothing guarantees that that simple logo would assuage critics. Simply repeating that “derivatives don´t kill people, people kill people” is probably not the best way to calm heated tempers when faced with large losses and blood-thirsty demands for explanations.
A better approach for derivatives apologists would be to calmly explain that losses, including big ones, are just one of the natural, normal, and possible outcomes of any derivatives transaction, not matter how complex or simple it may seem. With derivatives you can win big, but you can also lose big. It´s just the nature of the game. When someone suffers a derivatives-induced setback, it doesn´t necessarily mean that something fraudulent, corrupt, or inappropriate was taking place. The hand of the devil had nothing to do with it. Once you decide to bind yourself to the contract, you become exposed to the possibility of suffering losses were the underlying market to go against you. If you didn´t know this beforehand, then you have only yourself to blame. If you knew it, and you are honest, then you shouldn´t whine when things turn sour.
