The more that markets are united through derivatives, the more systemic risk is created.

Derivatives exist to subvert regulations, at least the regulations that don’t involve derivatives.  Ideally, derivatives allow those that want to take on a given risk, to have the ability to do so.  And the same for laying off risk.

But here’s the difficulty.  You can create all the derivatives you want, but total risk never goes away, it is only shifted.  There are many idiosyncratic risks for which there is no natural counterparty, i.e., one that faces the opposite risk.  What does it take to get someone to speculate on a risk?  Well, you have to offer them good terms, such that on average, they have the expectation of a profit.  The speculator may try to delta-hedge, and/or cross-hedge his risks, or he may not.  But the speculator is usually in a weaker financial position than the hedger.  Let me give an example:

In the insurance world, with a few exceptions, large direct writers have higher ratings than reinsurers.  And for what few reinsurers of reinsurers there are (“retrocessionaires”) they usually have lower ratings than the reinsurers.  There is a tendency for the economic world to arrange itself like a Collateralized Debt Obligation.

Think about it.  In a CDO, the junior tranches insure those that are more senior against loss.  In exchange, they are offered a higher yield.  That’s what goes on with those that speculate with derivatives.  The one being insured typically gives up some economics to the speculator.

Now if this goes on in a small way, there is no trouble.  But if large numbers of parties lay off their risks in this way, a large amount of  risk is in the hands of speculators which don’t have the best balance sheets.  It’s not as bad as people holding stocks in 1929 on 10% margin, but you get the idea.

Anytime risk is concentrated in the hands of those less well capitalized, there is heightened systemic risk.  Think of American International Group Inc (NYSE:AIG) writing gonzo amounts of subprime AAA RMBS CDS for a pittance.  Everyone on Wall Street took advantage of them, except for one thing — because everyone was insured by AIG, no one was truly insured by AIG.  If the Fed hadn’t stepped in, who knows who could have been insolvent — and that’s what should have happened, with the regulators letting holding companies fail, but protecting regulated subsidiaries, so that ordinary people would not be harmed.

When risks are in the hands of those with weak abilities to bear risk, not only are the weak affected but the strong also.  The strong, thinking their risks are covered, lever up more because they aren’t worried about the risks.  When the weak fail, and the strong find that risk is shifting back to them, they find that they themselves are hard-pressed, because they don’t have so much equity to cushion the losses.

There is no free lunch with risk.  The most we can do is try to analyze who is bearing the risk.  If it is in strong hands, we don’t have to worry.  If it is in weak hands, perhaps it is time to reduce risk, and not synthetically, but by genuine sales of assets.

If we want to solve this problem we should require insurable interest, and only let hedger initiate transactions.  But who will take on the lobbyists?

By David Merkel, CFA of Aleph Blog