A piece in the FT today explains the discussions going on concerning the tightening of regulations against the speculative use of Credit Default Swaps, and other ‘derivative’ financial instruments.
They report –
Speaking to a parliamentary select committee on Tuesday, Lord Turner said that regulators should seriously consider preventing investors from buying so-called credit default swaps on both corporate and sovereign debt unless they are using it to hedge an existing investment. CDS provide insurance against default of a debt instrument.
While playing down the effect of so-called “naked” purchases of CDS – buying credit default protection without ownership of the underlying bond – Lord Turner said that a ban on speculative purchases “is something that should be discussed”.
He said: “It may be that even if you banned it, it wouldn’t make a big difference [but] there are questions as to whether you should be allowed to take out an insurance contract where you don’t have an insurable interest”.
That makes a lot of sense, up to a point. Why should someone be allowed to take up a position on a country or a company’s creditworthiness if they don’t have any other business with that company or corporation that needs protecting? The same, however, could be said for nearly every Forex trade that ever takes place, and every commodity trade. Unless you are a cocoa grower, or purchaser, what right do you have to swing the price around by buying or selling cocoa futures?
However if every trade has to be approved by a regulator, it would be nigh impossible to police such a system on a worldwide basis with fast moving markets, without bringing volumes crashing down to ever lower levels, bringing on a fall in economic activity.
The financial industry is creating more and more tradeable instruments which package risks conveniently for investors such as ETFs, which have been a key factor in the surge in commodity prices. For example they played a key role in the platinum gold and silver price surges in recent years. If the spot markets were controlling prices, without futures players and ETFs, commodities would all be far cheaper than they are, and trade in the real world more stable and healthier.
The people trading in the real industries such as jewellery, which is my business, are dependent on those commodities having a fair price, and with volatility in prices becoming a daily fact of life, people are being driven from their jobs, as it makes customers cautious. Likewise consumers were forced to pay barmy prices for oil and rice in 2008, when the prices were surged by speculation, only to crash again, causing serious need and hunger in poor countries and supply difficulties. It is simply too easy for investors to take positions in markets and rock them, without having any responsibility for the consequences of their actions.
The problem, though with boxing in investors is that the investor’s view will be expressed one way or another. If they cannot trade CDSs over Greece’s debt, for example, they will turn their attention onto the Euro instead. And that is what is happening now. With Greece, the regulators are trying to buckle a tight belt onto a lady with a fat waist. The waist goes in OK, but the fat just spills over the edges of the belt. A looser belt might work better.
The FT continues The manager of one multi-billion London-based fund said: “Hedge funds are now expressing the same view on the weaknesses of individual eurozone countries via the euro”.
An estimated $12.1bn of short positions are outstanding against the currency, according to the Commodity Futures Trading Commission. At the beginning of February, there was just over $7bn of short positions it.
If the activities of hedge funds become limited to Forex, currency volatility will surge, as happened to Sterling last week. The next stop will be to regulate trade in Forex, until that market is nailed down, and people are only allowed to hedge real positions that they hold there too.
While there are good arguments for increasing the regulations governing speculation, the better way than trying to identify what each trader’s motives are, would be to simply raise the cost of speculating. If ETF investors, currency speculators and other risk-negotiators had to deposit as cash 1-5% of the value of the goods they were shorting or buying ahead, that would slow them down a bit while not boxing them in too hard. If the market is really wrongly priced, the trades will still happen, albeit more slowly.
The regulators shouldn’t stop people buying whatever insurance policy they need or want. They just need to raise the price of buying the insurance policy, or what amounts in many cases, to a straight gamble. By trying to stop the trades altogether, as they are doing, by threatening hedge funds to get out of the market, they concentrate the buying of insurance, or the hunger to profit from changing prices all onto one point.
That point, by default, is becoming the Euro. By killing off completely the markets which might have helped them to negotiate a tight corner, after being too lax in the past, the regulators are now going to overdo it and end up crashing their own castle of dreams.