Econobytes for June 27, 2013

Financial markets exist to move capital from investors to users, and the value of the financial markets should be determined by their efficiency in intermediating these flows of capital. Unregulated markets are chronically inefficient using this standard and cost the economy enormous amounts each year, creating stresses to the system that make systemic crises inevitable.
 
In a newly published report, Wallace Turbeville, Demos think tank Senior Fellow and former Goldman Sachs banker, finds that use of swaps, exempt from Dodd-Frank transparency and clearing requirements, creates substantial inefficiencies in the capital intermediation process and impairs the interaction of supply and demand in response to price movements. In today‚Äôs edition, Wallace Turbeville on evaluating the use of derivatives as hedges of operational and financial risk:
 
Swaps are not assets that can be bought and sold, like shares of stock or barrels of oil. They are bi-lateral contracts requiring performance in the future. Swaps cause large amounts of volatile and uncapped credit exposure to accumulate in the economy.

  • The only way to eliminate the future risk of price changes associated with being a party to a swap contract is to enter into a mirror image swap contract, taking on the opposite performance obligation.
  • This elimination of price risk is conditional: if the opposite party to the mirror image swap fails to perform, the original risk will be realized.

The common description of swaps as price risk elimination devices is wholly inadequate.

  • If a party uses a swap to fix the price of an asset or instrument synthetically, it elects to experience the current, market-based expected forward price of that asset or instrument.
  • That consequence replaces both the possible negative consequence of an adverse price move and the possible positive consequence of a favorable price move.
  • In a market-priced swap, the probability of adverse and favorable price moves are equal.
  • Swaps are used to hedge, i.e., trade uncertain price consequences (which could be positive as well as negative) for certain ones.
  • This trade-off is conditional upon performance by the counterparty. Thus, the value of the hedge must be reduced by the probability of default and other risks.

The process of capital intermediation transmits pools of money available for investment to capital users, companies, governments and households, for productive investment.