Using Daddy's credit card

Yes – we are learning, for the countless time. Derivatives markets need bailing out. Remember 1997 in Thailand? Or even 1994 in Mexico … and of course there is Japan back then, too, with the options crisis that brought down Barings bank.

Because derivatives are essentially cash-less instruments – meaning gains and losses are only realized at the expiry date of the instrument – when they go horribly wrong for the majority of speculators, someone is left having to pay the bill. That organizations is also known as the Federal reserve.

There has been much criticism recently by market commentators about the Fed’s bailout packages for mortgage backed securities – a type of derivative constructed by repackaging high-risk debt and selling it at a premium to a speculator. But in reality, who else is going to pay the bill? There is a contract at the end of every derivative essentially saying “pay the winner” (the “writer” or the “customer”, in this case the “writer”) – which sort of works like an I.O.U.

If we are going to have market employing derivatives, one of the facts we have to face is that sometimes there are going to be scenarios where too few people in the market can afford to pay the bill at the end of the night – in which case, Daddy’s credit card has to take the whack. As every parent knows – if you don’t like it, don’t have kids. And as the Federal reserve has discovered in recent years – if they don’t like, the only thing they can do is to try and prevent derivatives proliferation or markets in the first place.

Thankfully for all, the Fed, as in the mid-90’s, is playing the responsible parent this time around.