Derivative is Not a Curse Word

I would like to detoxify the word "derivative". The word itself has taken on a negative meaning in the eyes of many because of the unregulated excesses of things like bundled mortgage securities and ill defined interest rate swaps.

A derivative, by the way, is any type of financial security that derives its value from some underlying security or index.  So S&P 500 futures and options are derivatives, because their value is based on the combined value of 500 stocks in the index. IBM options are derivatives as they derive their value from the price of IBM, and so on.

The problem with the unregulated  derivatives is that they are traded "over the counter" meaning not through an exchange but as an agreement between two parties. There are/were lots of problems with this. Counter-party risk, for instance. If one party of the transaction blows up the other side, through no fault of there own, loses money. Lack of transparency is another problem. There is no true price discovery as takes place in an auction market. Knowing fair value is another. The buyer can put in his books they're worth 7 and the seller can say they're worth 2 and who is to say who's right?

Exchange traded derivatives, on the other hand, eliminate all of these problems. There is no counter party risk as the exchange is in between all transactions. There are strict margin requirements which helps control over leveraging. There is true transparency and price discovery as traded prices are there for all to see and fair value can be defined for accounting purposes as the derivatives are "marked to the market" at the end of each trading day.

So my solution is simple. Require all financial derivative contracts to be exchange traded and exchange cleared. No back room deals between parties such as the late and unlamented Lehman Bros and Bear Stearns. Transparency of accounting, transparency of price and sufficient margins all create a safer marketplace for everyone.

List them on the exchange or don't let them trade! Sometimes complex problems have simple solutions.



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