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«Global TrusT and EThics in FinancE Innovative Ideas from the Robin Cosgrove Prize Carol Cosgrove-Sacks / Paul H. Dembinski Editors Trust and Ethics in ...»

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Derivatives based on physical products originated in the agricultural markets, covering everything from lemons to oil. They can be said to have originated 4,000 years ago.1 Even today derivatives based on physical products remain crucial and important markets. Yet, within the last thirty years there was a substantial growth in financial derivatives, based for example on treasury bills and bonds. They have spread in form, with new contracts being invented constantly. The invention of derivatives made it possible for participants in the global financial market, ranging from international corporations with sophisticated financial Cp. Swan, E.J.: Building the Global Market. The Hague: Kluwer Law, 2000, p.


212 Trust and Ethics in Finance operations to households with mortgages, to better cope with risk – be it the risk of changes in commodity or stock prices, exchange rates, interest rates or market liquidity. Since the 1970s the range of futures and options contracts trades around the world increased tremendously. New hedging possibilities opened up so that those who want to reduce the economic uncertainty surrounding them are allowed to do so at a market-determined price, whilst those who are better equipped and willing to bear certain risks have expanded opportunities. Today the derivatives market’s notional value is estimated at over $583 trillion2 –about $100,000 in derivatives contracts for every person on the planet. Such developments highlight the importance of understanding the risks inherent in derivatives as well as their effects on society.

Why they are ethically relevant

Economists in recent years have devoted an extraordinary amount of time and attention to the study of financial derivatives. Still, the symptomatology of derivatives trading reveals them to be rather an ethical, not just an economic or mathematical, problem. The article will try to illustrate the ethical problems posed by financial derivatives. The heart of the argument will be that derivatives do not simply provide a means to exchange financial risk but in fact can also create risks and future uncertainties that might be – in certain cases – ethically inacceptable. I will unfold this argument, and its implications, in two ways. First, I will tackle the question why we do and should care about derivatives. I will show that, from a social perspective, the transformation and dispersion of risk, caused intentionally by trading derivatives, might pose problems as derivatives have been involved in the current financial crisis as well as in other disastrous financial debacles. Second, I will identify three criCp. Bank for International Settlements: Semiannual OTC Derivatives Statistics at End-June 2010. Amounts Outstanding of Over-the-Counter (OTC) Derivatives, www.bis.org/publ/otc_hy1011.pdf (28.03.10).

Financial Derivatives and Responsibility 213 teria or guidelines that are necessary when dealing with financial risk, especially when trading derivatives.

Thus far, the examination suggests that derivatives deals probably benefit traders. Derivatives make it possible to commoditise risk and hence to buy, sell, restructure and price risk. Thus, derivatives change the way corporations and banks manage their business and make decisions on risk. In addition to that, derivatives are often a cheaper alternative to investing in the underlying asset. Their significance lies in the lower transaction cost as well as in the possibility of price arbitrage.

Price arbitrage refers to the ability to trade on differences between the price of the derivative and the price of the underlying asset, or between prices in different markets. Hence, up to this point, we care about derivatives in a positive way because they serve at least the functions mentioned above. But this approach doesn’t seem to be sufficient. For it is still questionable whether such trades benefit society as a whole. In order to go further and to work out why everyone should care about derivatives (even non-traders) it seems important to separate the private and social benefits of financial derivatives.

Private benefits and social costs?

From a private perspective, it doesn’t appear dubious at all that derivatives provide efficiency and benefit traders.3 For individual parties, derivatives constitute a valuable means in dealing with risk. We can conclude that, within the microethical sphere4, emphasis is placed solely on the fact that derivatives always have two sides, a long one and a short Efficiency for example through intense competition between intermediaries, providing greater transparency, liquidity and price information. It is in fact not always clear that derivatives benefit traders, see also Stout, Lynn A.: Insurance or Gambling? In: Brookings Review 14, 1 (Winter 1996), pp. 40 ff.

For further elaboration on the difference between microethics and macroethics and the importance of financial macroethics cp. Steigleder, Klaus: Ethics and

Global Finance. Outline of a Macroethical Approach. In: Michael Boylan (ed.):

The Morality and Global Justice Reader. Boulder, Co: Westview Press, 2011, p.


214 Trust and Ethics in Finance one : Individual traders decide which position to take and which risk to manage. A counterparty enters into a contract in order to take over the risk the first party is not willing to bear or vice versa. Both parties act on their own behalf. And, at all times, the positions even out and for every winner there is a loser. To put it another way: trading in derivatives is a zero sum game: One derivatives trader’s gain is necessarily balanced by another’s loss. If derivatives trading were costless, the positions would just cancel each other out. Derivatives markets would move wealth around but neither increase nor decrease total wealth. But trading derivatives is not costless. Stout estimates (conservatively) that derivatives are costing investors, as a group, tens of billions of dollars.5 Still, ex ante, both parties experience an efficiency gain because derivatives enable them to manage risk they might otherwise have to bear. In this context, the ethical analysis of derivatives transactions focuses exclusively on the obligations or duties of people in financial contracting and fairness in market transaction, whereas ethical behavior is constituted primarily by the contractual relation in which one party agrees to assume certain duties – in return for some compensation, of course.

From a social perspective, it is not as simple as that. As the International Monetary Fund (IMF) itself recognised already in 1994, although derivatives can be used effectively to reduce the risk borne by individual agents, they cannot reduce the overall risk in the system but rather can “only transform and re-allocate” risk.6 At first sight, the transformation and re-allocation of risk may not pose a problem. However, if we take a look at the financial crisis of 2007/08, a flood of losses has been reported by banks, corporations, funds, state and local governments. The leading cause of the crisis that spread out across the globe was the transformation and re-allocation of risk, wherein the use of derivatives played Cp. Stout, Lynn A. “Insurance or Gambling?” in: Brookings Review 14 1, Winter 1996, p. 41.

IMF Survey, Banks and Derivatives Markets: A Challenge For Financial Policy, 21 February 1994.

Financial Derivatives and Responsibility 215 a major role. A proliferation of further forms of derivatives took place, involving not only asset packaging but the breakdown of risk into smaller and smaller discrete units. RMBS and CMOs were designed to assemble large packages of loans and divide them into slices of obligations that are sold as having different risk and return characteristics.

These instruments aimed at dispersing risk so that risk would not have to be carried by the lender who made the loan but could be traded like a bond or share of stock among different financial investors. At their heart lies a calculated analysis of risk and an attempt to divide it so that parties take the risks they want and lay off those they do not want.

Systemic risks and costs The risks traders deal with on the micro-ethical level play a major role from a macro-ethical perspective. Individual traders try to seek security through calibrations of risk that will, one hopes, reduce their imagined losses or harms. But, if they are successful in predicting the unknown (and yet uncertain) future and make spectacular gains, they can also make spectacular losses, as various financial catastrophes illustrate. One may think, for instance, of the bond crisis in 1994. Just ahead of the crisis it was widely reported that George Soros had lost $600 million speculating with derivatives against the yen. When the bond market crashed, concerns came up as many derivatives traders (mostly hedge funds) suffered heavy losses. It was suspected that the traders could start to default on their bank loans and that they could spark a chain reaction affecting the whole financial system. From a systemic perspective, the risk transformed and transferred by individuals may threaten the whole financial infrastructure of the economy – interest rates, mortgage rates, the value of personal and corporate pensions. So called systemic risk may also heighten the possibility for large companies to go out of business. As the current financial crisis shows, even banks may not be too big to fail when confronted with systemic risk. As we have seen in the crisis of 2007/08 systemic risk can bring about a systemic shock that afTrust and Ethics in Finance fects a considerable number of financial institutions or markets in a strong sense. The general well-functioning of the financial system may be impaired in the case of such an event, which means that i. a. savings may not efficiently be channelled into investments and an extreme credit rationing in the real sector (credit crunch) may result. Possible consequences of systemic risks such as the increase of the unemployment rate and with that poverty and homelessness have been in the news since the beginning of the last financial crisis. Systemic risks are threats to the system as a whole, which means that they differ from risks that menace specific households, firms, financial institutions or even markets. They can be catastrophic for an economy.

As leverage is a key component of systemic risk, derivatives may play their part in it. Derivative innovations made it possible to hedge risk but also made it possible to engage in highly leveraged speculation.

In the boom preceding the financial crisis 2007/08, leverage increased massively along with the supply of illiquid high-risk derivatives.7 Derivatives also tend to strengthen linkages between market segments and institutions. With that, disruptions in one market are more likely to spill over to and affect other markets, which may result in a domino effect. In addition to that, banks had a strong incentive to create products so complex that they could not be sold on exchanges at all.

Eighty percent of derivatives are now sold over-the-counter in nontransparent private deals.8 Concealing the risks that traders take and disperse adds opacity to the market and poses an unseen risk to the functioning of the financial system should the traders fail. When the risk materialises it may not be possible to prevent a system collapse. Therefore we need to take over responsibility for the risk itself before it’s too late – before the risk materialises.

Crotty, James: Structural Causes of the Global Financial Crisis: A Critical Assessment of the ‘New Financial Architecture’. Working Paper 2008-14. University of Massachusetts Amherst, August 2008, p. 1-61, p. 47 f.

Cp. ibid, p. 25.

Financial Derivatives and Responsibility 217

Risk, the unknown unknown

It can be concluded that, on financial markets, risk has become a commodity that can be bought and sold according to mutual agreement and that seems to be even more flexible than any other product. Here, the term “risk” refers to both possible (negative) events to which probabilities can be assigned as well as to possible (negative) events to which no probabilities can be assigned. Whereas the former definition describes risk in a narrow sense, the latter definition corresponds to what we call uncertainty. To the economist, risk is a term of art that means variation in outcome, chances of gains as well as losses. Consider someone who offers his friend the choice of either receiving a euro or flipping the euro and getting two euros if it comes up heads, and nothing if it comes up tails. A 50 percent chance of receiving two euros is, statistically speaking, worth one euro. Flipping the coin is riskier, however, because two euros or nothing is a more variable outcome than one euro with certainty.

In the financial world, very few problems are akin to coin-tossing problems. In coin-tossing situations we are faced with sharp and objective probabilities which our decisions can be guided by. A typical coin toss is not uncertain, because we know with surety that the probability of either event is 50 percent. Financial decisions are often influenced by much more complex and nuanced conditions. With regard to derivatives, we can assert that their value changes over time and depends on the future behavior of the underlying financial commodity (prices, interest rates etc.) from which the derivative is derived. This behavior is, as of today, unknown. Depending on the unknown future, the risk associated with derivatives is therefore much more difficult to assess. In dealing with derivatives, we cannot know the risks we face, neither now nor in the future, but we must act as if we did, when we strike a deal.

218 Trust and Ethics in Finance

Risk and ethics

As a matter of fact, risk is inherent in all business activities regardless of the economic order. The critical concern, therefore, is not whether the element of risk is present in a certain business activity. (For risk creates opportunities for economic activity, investment and commerce that contribute to a well-functioning and productive economy.) It is rather the impact of a given transaction on the aggregate level of risk the community has to bear. On the level of the individual trader, risk can be reduced or remains the same by being transformed and transferred.

But this is not the case on the systemic level. If a derivative transaction resulted in an increase of the aggregate level of risk, it might negatively affect economic activity and burden those who are not primarily involved in the transaction. From an ethical perspective, derivative transactions have to be considered as social situations of risk as risks may have to be borne by individuals or groups who have not created the risk.

Thus, derivatives have social externalities. Even if the damage or the loss incurred is only potential, as decisions are made under the conditions of uncertainty, they are of ethical relevance.

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