Welcome to European Tribune. It's gone a bit quiet around here these days, but it's still going.

Why are derivatives legal?

by Lupin Wed Oct 8th, 2008 at 12:05:51 PM EST

This may be a very naive or stupid question, but I would like to know the answer.

I always understood that it was illegal for someone (a person, a corporation) to repay commercial paper ("traites"?) with more commercial paper.

It was a offense dubbed "cavalerie" in France because the penal code considered it akin to creating new, and therefore counterfeit, money.

Only sovereign nations can create money, I suppose.

Why, therefore, is the entire derivatives industry legal?

According to this graph on Wikipedia, the total value of all the derivatives is in excess of $500 trillion, while the entire world wealth may be perhaps only half of that.

Wasn't that creating counterfeit money, in effect?

So why was it legal?

Are you sure (your link did not work) that it's the total value, not the total value traded?

Earth provides enough to satisfy every man's need, but not every man's greed. Gandhi
by Cyrille (cyrillev domain yahoo.fr) on Wed Oct 8th, 2008 at 02:28:25 PM EST
That may be the notional value but that doesn't mean that that's the amount that can be lost.

A vivid image of what should exist acts as a surrogate for reality. Pursuit of the image then prevents pursuit of the reality -- John K. Galbraith
by Migeru (migeru at eurotrib dot com) on Wed Oct 8th, 2008 at 04:14:19 PM EST
[ Parent ]
I've heard more than a few people ask that very question. Some of them even asked it before the current kerfuffle.

I guess it's legal cos financial institutions make a lot of money from it and pay the governments a lot of money to ensure nobody looks too closely.

Plus most people in government are lawyers or careerists who don't understand finance who are advised by either civil servants who are generalists (ie don't understand finance) or paid lobbyists with a vested interest in filtering out the bad news. So nobody who knows what they're talking about who isn't on the take ever gets to look at these things dispassionately and get a view on whether it should continue. Or at least, nobody with the power to do anything about it.

Like the ratings agency that mixed trash in with the good stuff cos they knew nobody else knew any better and nobody was watching them, so why not ? More profit and treble bonuses all round.

keep to the Fen Causeway

by Helen (lareinagal at yahoo dot co dot uk) on Wed Oct 8th, 2008 at 03:37:54 PM EST
ps - Nice to see you around.

keep to the Fen Causeway
by Helen (lareinagal at yahoo dot co dot uk) on Wed Oct 8th, 2008 at 03:38:19 PM EST
The notional value of derivatives may be $500 trillion but in reality much less money is at stake.

Suppose I lend you £79  and you lend me €100 and we set each loan to be variable-rate at the respective central bank's base rate (4.5% ad 3.75%) respectively. We agree to pay each other interest each day.

Because the exchange rate today is 0.79 €/£ no money need change hands when setting this up. We can also agree to put some collateral (say, you post €10 and I post £8) in escrow and if exchange rates fluctuate we will top it up by the difference between the nominal values of the two loans. If we can't keep at least the initial amounts in the accounts the contract gets cancelled at nearly zero cost because the notional values nearly match and there's enough money in the escrow to make up the difference.

The notional value of this arrangement is €200 at inception, but in fact only €20 are posted as collateral. The only risk is that exchange rates will fluctuate more that 10% in a day and the party on the wrong side of that movement won't have enough cast lying around. But the other party is covered for the first 10% from the escrow account.

Leaving aside the question of why should we want to enter into such an agreement (called a currency swap) how would you justify makig it illegal, and which amount is more representative of the quantities involved? €200 (notional) or €20 (collateral) or the average daily payment over time?

A vivid image of what should exist acts as a surrogate for reality. Pursuit of the image then prevents pursuit of the reality -- John K. Galbraith

by Migeru (migeru at eurotrib dot com) on Wed Oct 8th, 2008 at 04:13:39 PM EST
... which is really in the spotlight here but the credit default swap.

In the credit default swap, the amount to be paid in the event of default is not in escrow anywhere. And, of course, since the party acquiring the notional coverage of the CDS need not be holding the bond that is it covering against default, it is quite possible for the exposure to default via CDS to be many multiples of the actual assets of the firm.

While originally focused on the moral hazard, the requirement that an insurance policy can only be issued to someone with an insurable interest means a much lower ceiling on exposure to systemic risk in the insurance market proper than in the quasi-insurance CDS market.

Now, an uncertain part of this multiple exposure is laying off the exposure by balancing a CDS exposure with CDS coverage ... but as the Aon / Societe Generale (apologies spelling) case showed, small differences in the description event can lead to that presumed cover vanishing in the event.

Indeed, I can see an argument for treating CDS where the acquiring firm owns the bonds (or other asset) as insurance and regulating it as such, and treating naked swaps as speculations and leaving them in the YOYO basket.

I've been accused of being a Marxist, yet while Harpo's my favourite, it's Groucho I'm always quoting. Odd, that.

by BruceMcF (agila61 at netscape dot net) on Wed Oct 8th, 2008 at 04:35:48 PM EST
[ Parent ]
Thank you all.

Here are the correct wiki links:



by Lupin on Thu Oct 9th, 2008 at 02:03:36 AM EST
[ Parent ]

Go to: [ European Tribune Homepage : Top of page : Top of comments ]