Public outrage at Wall Street Banks has been apparent for more than a year. Democrats are capitalizing on this opportunity as they seek to pass a financial reform bill that increases regulations on large financial institutions. One of these key provisions being debated is to ban banks from having their own financial derivatives trading desks.
This is no time to stifle financial innovation. This is the time for Congress to reduce regulation and enact policies that foster innovation in new financial derivatives and support Wall Street profitability. It’s in the interest of the country.
The argument goes that speculation in financial derivatives caused the economic meltdown. Therefore this speculation is only good for banks profitability and bad for the average citizen. As a nod to the fundamental purpose of these instruments, Democrats say laws will be written that only allow banks to trade derivatives for the purpose of client risk management – hedging to offset fluctuations in raw material prices.
Democrats are missing the boat. Speculation and hedging go hand in hand and one cannot exist without the other.
Hedging is a strategy where companies buy securities to offset risks associated with fluctuating raw material prices. For example, a farmer will sell corn futures to offset the potential for declines in corn prices, effectively locking in a price. This is a fundamental business strategy that can be employed in any industry from energy, to agriculture to debt markets.
Financial derivatives are tools that are used for hedging purposes. A financial derivative is a piece of paper that gets value from the underlying commodity it represents. Instead of making or taking delivery on the commodity at expiration, the derivative is settled against an index that represents the physical commodity price. Derivatives are a key component to effective hedging as they allow companies to manage risk without worrying about the financial and logistical burdens of dealing with the physical commodity.
Another key component to effective hedging is market liquidity. Regulating or outright banning banks’ financial derivatives trading desks could have crippling effects on these markets liquidity and efficiency.
Effective hedges are not possible without speculators – the companies that make the markets. Wall Street banks run speculative trading desks for physical and financial commodity products. These companies act as market makers, always willing to buy and sell at a certain price. They place bets not only on the direction of a single commodity, but on the differentials between physical commodities and financial derivatives, and on the differentials between products along a supply chain. For example, a speculator could bet that the spread between crude oil and motor gasoline is undervalued and could widen.
This speculation brings efficiency to commodity supply chains by providing liquidity. A ready supply of speculators willing to buy and sell at a given price ensures that markets stay in line with supply and demand fundamentals. Speculators smooth out ups and downs in markets by taking contrarian positions. Market liquidity ensures a narrow gap between a buy and sell price, called a bid/ask spread. A narrow bid/ask spread ensures that a hedger can unwind a position in a financial derivative at will with minimal risk. When bid/ask spreads widen due to lack of market liquidity, the risk to a hedger of participating in the market is greatly enhanced.
Without financial speculators market efficiency breaks down. Companies that sell key goods from gasoline to corn to plastic bags cannot predict profitability. They will go out of business. Supply chains fall apart, gas stations run out of fuel and grocery store shelves will become bare. For all of Congress’ talk about consumer protection, trying to stifle speculation will achieve the exact opposite.
Wall Street speculation is the true consumer advocate. If a financial reform bill bans banks from trading derivatives, Congress needs to kill it.