Why It Should Be Illegal to Gamble Using Financial Derivatives

Commentary about business and finance.
April 4 2012 4:26 PM

Not Worth the Gamble

Why it should be illegal to speculate using financial derivatives.

(Continued from Page 1)

For all these reasons, we advocate the creation of a Financial Products Agency that would be charged with determining whether a derivative is likely to act primarily as a vehicle for speculation. This agency would have to weigh the harms created by speculation against whatever benefits would result from this new derivative.

In principle, for example, bets on the presidential election could be used for insurance. If you think you will be impoverished if Obama is re-elected, you could, in theory, hedge against his re-election by betting that he will win. But in reality, the effect of the presidential election on your income is probably close to nil. Thus, the CFTC was rightly skeptical of these new political events contracts—the mere possibility of insurance is not enough to refute the likelihood of large quantities of speculation.

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A second potential benefit of allowing trading in derivatives is the information that they provide to market participants. The knowledge of the likely outcome of the presidential election provided by the wisdom of the crowds is useful for planning by businesses, individuals, and governments. But that information is only valuable to the extent that it enables real economic decisions to be made more effectively. Creation of derivatives may do as much to spur wasteful expenditures as to supply valuable information to markets in a timely fashion. Innovators pressing for the approval of a new product would have to show that the additional gains from the latter outweighed not only the harms from the former, but also any net costs from speculation compared to insurance.

Other arguments made in favor of allowing derivatives to trade unchecked are mostly variations of these simple tests. For example, it is often argued that derivatives help create liquidity in markets, making it easier for individuals to take on or unwind desired positions. But this just pushes the analysis back one step: Liquidity is neither inherently good nor bad. If derivatives make markets more liquid for speculators, they are harmful; if they make them more liquid for individuals seeking insurance, they are beneficial.

The simple logic of projecting the demand for a product arising from insurance compared to speculation provides a sound basis for determining whether derivatives should be traded. We know this is possible, not fanciful. The same logic was the basis for the CFTC’s order prohibiting political events contracts, and similar demand projections are already used by the Department of Justice and Federal Trade Commission to determine whether mergers should proceed because of the synergies they allow or should be blocked because they will reduce competition.

In a forthcoming article, we provide several examples of such analyses, arguing that credit default swaps, collateralized debt obligations, and many derivatives based on statistical properties of equity returns (such as correlation and volatility) should have been banned. On the other hand, we believe that index funds, derivatives based on real estate indices, and derivatives based on national income measures likely should have been allowed.

The larger question raised by the CFTC’s decision to ban political betting is why it does not use the same reasoning to regulate financial derivatives, which are conceptually no different from political events derivatives. The major difference between them is that financial derivatives have done a lot more damage.

Eric Posner, a professor at the University of Chicago Law School, is a co-author of The Executive Unbound: After the Madisonian Republic and Climate Change Justice. Follow him on Twitter.

E. Glen Weyl is an assistant professor of economics and law at the University of Chicago.