Why You Should Fear a Regulated Derivatives Market
I can’t figure out what I can see and what government can’t see. A regulated derivatives market will absolutely reek havoc on the financial markets as a whole. Here is why…
Collateralized Bets
The derivatives market operates as a system of very complex, very leveraged, bets between two different banking institutions. When an agreement is reached to bet on a particular security, index, commodity, Kentucky Derby winner, or even a weather pattern, one party has to put up a certain amount of collateral up with the opposing party. For instance, if Berkshire Hathaway were to make a $100 million bet with Goldman Sachs, Berkshire might have to put up $3 million to secure the bet. Think of it like paying a premium on an options contract.
Where Regulation Goes Wrong
When you break down the financial reform overhaul bill you’ll find that the scope the bill is centered around the idea that the financial system would work better if there were more barriers to becoming a giant. Larger banks, because of their inherent risks to the entirety of the banking sector, would have higher capital requirements. Huge markets like the derivatives markets would require greater collateral to make bets. WAIT! Right there. Greater collateral to make bets. Hmm, there’s the problem!
CREDIT CRUNCH
The same reason I’m against this bill is the same reason Warren Buffett is. His company, Berkshire Hathaway, which has a significant derivatives position, will have to come up with more collateral for all the bets it made in the past. The cost? Tons, tons, tons of money. More collateral means less equity for business operations, higher borrowing costs for those who need to, and more strain on already strained capital markets. This bill is a loser.
