Thursday, 19 July 2012

Derivatives Should Be Banned From Financial Markets

The idea that the financial products known as derivatives pose a danger to the financial system is nothing new. Commentators have been pointing this out for years. Most famously, Warren Buffett referred to derivatives as "time bombs" and financial "weapons of mass destruction." Recently a complex derivatives trade caused over $5 billion in losses at J.P. Morgan.

Derivatives are bets between two parties that are made today with a payoff in the future based on the value of some stock, bond, or index. One party will profit if the reference security or index goes up in value and the other party will profit if it goes down. These bets usually settle up every three months based on value at that time, and then a new calculation period begins. There are many variations on this basic pattern, but almost all derivatives involve some form of a bet in which gains and losses are calculated and settled-up periodically.

If derivatives are as dangerous as the commentators suggest, why are they permitted? If they are such a threat to the financial system, why does the size of derivatives bets continue to grow? The answers have to do with several myths the big bank derivatives players have created. These myths are false and distract interested parties from doing what needs to be done to ban derivatives. It's time to demolish these myths once and for all

[Posted at the SpookyWeather blog, July 19th, 2012.]

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