In Defense of derivatives: between Enron, WorldCom, and Global Crossing, the controversial financial instruments have gotten a bad rap. Here's the truth

Reason, Feb, 2004 by Gene Callahan, Greg Kaza

How important are derivatives to multinationals? Consider this passage from IBM's 2002 annual report: "The company operates in approximately 35 functional currencies and is a significant lender and borrower in the global markets. In the normal course of business, the company is exposed to the impact of interest rate changes and foreign currency fluctuations, and to a lesser extent equity price changes. The company limits these risks by following established risk management policies and procedures including the use of derivatives and, where cost-effective, financing with debt in the currencies in which assets are denominated."

For the economy as a whole, the benefit of such activities is a simple extension of Adam Smith's 227-year-old insight that the division of labor increases overall productivity. By employing derivatives, David Bowie can focus on making music, the farmer can concentrate on farming, IBM can specialize in computer manufacturing, and financial market traders can worry about pricing assets and evaluating their risk.

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Still, derivatives are newfangled enough that traders, CFOs, accountants, and investors remain on the learning curve for properly using and analyzing these instruments. We can expect these specialists to make miscalculations, occasionally serious ones. The media and general public, meanwhile, are a few steps further behind in understanding.

Take Enron. Derivatives did play a role in what was the second-largest bankruptcy in U.S. history (behind only WorldCom), but not in the way most people think. The Houston energy company did not go bankrupt because it lost money in derivatives trading. In fact, Enron was tremendously successful in its trading operations, racking up billions of dollars in profits. As documented by economic historian Frank Partnoy, the company went trader not because it was losing money but because it tried to use these profits to disguise heavy losses in its consulting and technology businesses. When the accounting shenanigans were exposed, the company's credibility evaporated, as did its sources of credit and cash. The company was killed by a lack of cash flow, not a lack of profits.

But there are other troubling aspects of derivatives. For one thing, they may be used in what is called "regulatory arbitrage." Partnoy notes, in his financial history Infectious Greed (2003), that "bank regulators, by tightening their focus on banks to reduce their risks and prevent a banking crisis ... pushed credit risks onto other, less regulated institutions." in other words, while it may have made sense in other ways for banks to retain more of their own credit risks, the regulatory environment prompted them to trade that risk away. Similar types of regulatory arbitrage have motivated other economic actors, such as insurance companies, to enter into derivative contracts that otherwise would have been unattractive to them.

It's clear that the legal system has a role to play in preventing financial scares. It is also clear that if a particular regulation is desirable, the use of derivatives to dodge it is not. If the regulation is not desirable, it is simply generating transactions that serve no purpose other than evasion, thus creating superfluous costs and transferring risk from specialists (such as banks and insurance companies) to the less experienced.