12.14.2011

Article Review: Derivatives: A Twenty-First Century Understanding

Derivatives are an oft-maligned and dangerous yet misunderstood and critical part of the modern financial system. While many Americans rightfully place some of the blame for the housing bubble on a system which could enable and even facilitate the creation of highly-rated credit default swaps on blocks of almost worthless debt, it is also true that derivatives allow companies and investors to manage risk and protect value. Like so many things from the financial markets to everyday life, derivatives can be very useful when properly utilized and exceptionally destructive when they aren't.

Unfortunately most of the policy-makers who have oversight over these instruments have little idea how they work, leading to disruptive under-regulation. Or at least that is the theory of one individual, Professor Timothy E. Lynch. In a recent article which appears in the latest Loyola University Law Journal, Lynch outlines some of the problems with derivatives and explains what he describes as a modern framework for derivatives. Under this framework, derivatives, which Lynch argues are defined both over- and under-inclusively currently, would be more appropriately redefined. In Lynch's estimation, this would ensure that policy can properly match the challenges presented by the myriad structures which exist. From the abstract:

"Derivatives are commonly defined as some variation of the following: a financial instrument whose value is derived from the performance of a secondary source such as an underlying bond, commodity or index. But this definition is both over-inclusive and under-inclusive. Thus, not surprisingly, derivatives are largely misunderstood, including by many policy makers, regulators and legal analysts. It is important for interested parties such as policy makers to understand derivatives, because the types and uses of derivatives have exploded in the last few decades, and because these financial instruments can provide both social benefits and cause social harms. This Article presents a framework for understanding modern derivatives by identifying the characteristics all derivatives share.


All derivatives are contracts between two counterparties in which the payoffs to and from each counterparty depend on the outcome of one or more extrinsic, future, uncertain event or metric and in which each counterparty expects such outcome to be opposite to that expected by the other counterparty. The framework presented in this Article will facilitate the development of more rational and comprehensive derivatives regulations, including (i) those required under the recently enacted Wall Street Reform and Consumer Protection Act of 2010 (the Dodd-Frank Act) and (ii) those addressing the particular risks associated with “purely speculative derivatives,” (those in which neither party is hedging a pre-existing risk)." (emph. added).

Throughout the article, Lynch describes different types of derivatives and tries to speak to an 'everyman' audience with analogies centered mostly around fairly common Super Bowl bets. The article is quite readable and doesn't present any incorrect information. In short, Lynch has written a very good primer on derivatives for anyone with a cursory understanding of these admittedly complicated products.

However, in suggesting that he has created a new framework for understanding derivatives, Lynch has reached too far. Nothing that he discusses in the article will be new or surprising for anyone with a better-than-average knowledge of financial market transactions. Market observers have been discussing the rise of interesting and unique instruments, including derivatives based on everything from box office receipts to weather events, for years. Political junkies have known for some time now that they can put cash down on elections. None of this is novel.

Where Lynch does discuss some more interesting, if not necessarily novel ideas, including his suggestion that derivative regulation should borrow from/contrast with both insurance products and gambling, the analysis is light and obvious avenues to contemplate further go unexplored as 'beyond the scope of the paper.' It is also not clear how he thinks, as a practical political matter, that responsibility for insurance contracts and gambling could be shifted to the realm of the commodities world, but perhaps I quibble.

It almost seems as if in identifying derivatives as a problem for America, Lynch has created a straw man to attack in the form of a lack of knowledge. Most market observers would agree that it isn't a lack of knowledge among politicians, but instead the political process itself which has led to the current state of regulatory affairs. Even taking a neutral stance on the question of whether or not more regulation is necessary, it is clear that it is the lobbying efforts of the financial industry and special interests which have led to the current regulatory regime, not an inability of regulators and congressional leaders to understand derivatives.

In short, to the extent that financial reform is necessary in America, and to the extent that derivatives should be some part of this reform, it surely isn't a lack of understanding and classification of financial products which has led to this necessity. Perhaps the best proof of this is information on some of the recent rule makings which have been handed down in connection with the very legislation Lynch claims requires clarification. It seems as if the respective agencies have a fairly good grasp of what derivatives are all about after all.

With respect to lawmakers, I agree that there may be some individuals in the Halls of Congress who don't sufficiently understand supply and demand, never mind derivatives. However, they aren't typically on financial committees and subcommittees. Nor are they involved with enforcement. And, even if one grants that a lack of knowledge has contributed to gaps in financial system regulation and enforcement, a paper which advocates for including a wider array of financial products in the commonly-used definition of derivatives doesn't seem to be the solution. It rather seems almost naive to think that gaps in the understanding of financial instruments could be filled by morphing definitions in an attempt to help usher in a new era of regulation and enforcement; surely the American financial system is in even greater danger than many already fear if that is the case.

Now, as noted, it seems as if the intended audience for this piece might be the average American. If this is the case, Lynch has come closer to identifying a group with a knowledge gap. But to the extent that he feels that grassroots understanding of financial markets will lead to substantive change, he is certainly contemplating a long-term and difficult battle.

To be fair, this paper has a companion piece referenced in the footnotes in which Lynch discusses purely speculative derivatives contracts further. As per several footnotes, he makes some policy arguments suggesting that such contracts without 'social benefit' should, to a large extent, be eliminated. Therefore, though we did not have an opportunity to review that paper, it is possible that the 'framework' described in Derivatives: A Twenty-First Century Understanding is fleshed out a bit elsewhere. He does make some note of this in the present paper. From the conclusion:

Appreciating this framework will also readily allow us to better differentiate between socially beneficial derivatives and those that are more problematic. Such problematic derivatives contracts include those in which both counterparties to the contract are mere speculators. These purely speculative derivatives contracts do not offer the risk-hedging value for which derivatives are rightly touted and are not used to facilitate any commercial transaction in the real economy. They are mere bets. And, as I argue elsewhere, the social benefits of PSD contracts rarely outweigh their costs. Therefore, except for limited circumstances, PSD contracts should be void for public policy reasons.

And here, finally in the conclusion of the paper, we may be getting to what Lynch seems to want to say all along; he is presenting this paper not as a way to better define derivatives as a mean to educate lawmakers and regulators, but as a way to capture certain activities which he finds objectionable and regulate them out of the market. If he is trying to say that speculative transactions should be regulated out of the market, that is fine, and its certainly a supportable assertion.

However, it is not what this paper set out to do, and it points to a lack of organization/structure between this paper and its companion piece. If Lynch's intent was for this paper to serve as an introduction to the companion, I believe that he could have dispensed with his conclusions far more perfunctorily and posted the work together. At the least he could have made the link between the two papers more explicit, including noting the relationship in the introduction rather than in a maze of footnotes. If indeed his purpose was to 'change' the definition of derivatives in an attempt to make a policy argument that many derivatives should be legislated away, again, this point should have been clearer, and not saved for the conclusion. That, as I have noted, is a supportable assertion, and there is no reason to obfuscate it in a re-working of definitions.

In any case, and whatever Lynch's intentions may have been, the title described herein does not live up to the lofty goals which the author set out for it. As a standalone, it is an entertaining read and could potentially serve as an introductory chapter in a resource for law students or novices desirous of an introduction to derivatives. As noted, it might also have served in a scaled-down form as the introduction to its companion piece, which again, I have not had the opportunity to review. Lynch also makes very good arguments about the system itself, noting that the 'multiplicity' of statutory and regulatory regimes make enforcement difficult. However, in its current form, it is not a new blueprint for understanding derivatives, and it is decidedly not the solution to financial system woes.


Editor's Note: This review was undertaken at the invitation of the editors of the Loyola University Law Journal, the journal which is publishing Professor Lynch's article. They provided a link to an early version of the article here, which will help them to track interest in the article. However, anyone more interested in reading a copy that is relatively free of distracting errors and less interested in having their page views tracked can read the article here.

7 comments:

  1. Lynch thinks people don't understand derivatives, so offers this "easier" definition:

    "All derivatives are contracts between two counterparties in which the payoffs to and from each counterparty depend on the outcome of one or more extrinsic, future, uncertain event or metric and in which each counterparty expects (or takes) such outcome to be opposite to that expected (or taken) by the other counterparty."

    Are law professors able to write lucidly only in brief bursts? What is this gobbledy-gook?

    Lynch means (as becomes clear in his moments of lucidity later in the article) that a derivative is "a bet." That definition is curt, elegant, and accurate. But Lynch's scholarship has been preempted by Billy Ray Valentine.

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  2. I think you give our legislators too much credit. They can be shockingly ignorant. Also the majority of their information comes from lobbyists, and staffers and SEC folk who want to work as lobbyists or bankers someday.

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  3. Josh Sturtevant14/12/11 16:56

    Thanks for the comments.

    To our Anonymous friend: It took a second, but the reference to one of the best documentaries on the financial markets was well-played!

    To Robbo: As I note in the review, even if it is the case that legislators are more ignorant than we would all hope, surely redefining derivatives to include more contracts is not a panacea.

    Indeed, you may have inadvertantly supported one of my points...that is that the problems with financial markets, to the extent that one believes they exist, are not a problem of knowledge but are more systemic.

    It is influence, whether from lobbyists or, as you put it, those who want to become lobbyists (and bankers) that have led to the system we have, not a lack of knowledge.

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  4. I think that Josh's comments bring some interesting issues to light, specifically the point about systematic problems with financial markets. I also think, however, that saying that it is the influence from the lobbyists or bankers is oversimplifying the issue a bit. There is a much broader systematic issue with policy making that creates complicated and frequently deficient legislation (see e.g. Dodd Frank) as well as a great deal of obstruction in the legislative process - especially when dealing with nuanced issues like derivatives legislation.

    I would be interested to hear your view on the recent moves that Congress has been making on the covered bonds front, specifically some opinions about systematic problems and why it seems that Congress (despite repeated efforts) has not been able to create a US covered bonds market.

    Excellent commentary and I look forward to reading future posts!

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  5. Josh Sturtevant15/12/11 20:21

    Thanks so much for the comment.

    You touch on something that we discuss quite often on the site; the paralysis of Washington. I agree 100% that this is a general problem on the federal scene that seems to be particularly acute when it comes to financial regulation.

    I certainly didn't intend to oversimplify arguments (particularly when I am making the claim that Lynch is doing just that!), so I should have brought this up explicitly.

    I would say that what I call 'systemic issues' in the review would include political indicisiveness. Further lobbyists, etc., which I do talk about in the article, are a part of what creates this indicisiveness. Therefore, I think that I was inferring what you call obstruction in the legislative process in my thoughts.

    However I agree that I could have been a little clearer that what I call 'systemic issues' includes good old-fashioned political gridlock. Hopefully anyone who reads this post will continue on to these comments and note this addition/clarification to the conversation.

    I am afraid that I might not be able to add much color with respect to any legislative efforts behind covered bond markets. I know that there has been agency support for facilitating covered bonds at Treasury. The Fed has also been a proponent of these instruments.

    However, I am not sure where Congress is one the issue. If I had one guess, I would speculate that the lack of action by Congress might have something to do with the fact that covered bonds show up on balance sheets. Though this seems entirely sensible, particularly with what has happened over the past few years with CDOs, it might just be another issue where sensible doesn't make sense for one of the parties.

    In this case, for example, I could see some Republicans declining to support legislation establishing, facilitating or regulating a formal covered bonds market, because I could see many banks being against that sort of 'intrusion' into how they are currently slicing and dicing mortgage packages (notably, if I am guessing right, it could be a great example of what I am discussing above; interests leading to obstruction in the legislative process leading to no and/or watered-down legislation).

    Alternately, I could see some Democrats, with the 'help' of interests which aren't too fond of Wall St. at the moment refusing to pass legislation dealing with covered bond markets if it didn't include, say, a prohibition on other, riskier instruments.

    As noted, however, this is all pure speculation based on general knowledge. I just don't have a lot of insight into the issue. If anyone reading this does, I would certainly appreciate insights, particularly if I am far off base.

    In any case, thanks for reading, and I will look forward to your insightful comments in the future.

    Josh

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  6. I think gridlock is generally healthy. There should be a heavy bias in favor of the system we have. But given the recent catastrophic failure if that system, it makes sense that gridlock (briefly) gave way to reform.

    I actually think that special interest groups are a natural and necessary part of reform. Mom and Pop investors have too small an interest and too shallow a depth of knowledge to craft detailed reforms.

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  7. Josh Sturtevant16/12/11 10:03

    Thanks for the comment.

    I agree that special interests are a valid part of the political process. Banks should have some say insight when it is being decided how they are run. So should groups who are for more bank regulation on the other side. Both have viewpoints that are healthy and helpful to bring to the debate, and it would be silly for politicians to not give them a voice.

    However, that wasn't necessarily my point in the piece. My point was more that, to the extent that we have a current system of regulation for derivatives, that it was/is more special interests who help to shape it than ignorance on the part of politicians. This statement was in reaction to Professor Lynch, who seems to be saying in his article that all we need for a 'better' system is more knowledge.

    Further, I intend for that to be merely a statement pointing to cause and effect, not blame. In other words, I am not saying whether or not I believe that we need more and/or different regulation of derivatives markets, just that the current state of affairs has a lot to do with interests (and more broadly the political process as another comment noted above).

    I am taking on enough in this particular post without also making judgement calls on whether or not the current regulatory system is appropriate or suitable for modern instruments and transactions!

    Josh

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