Tuesday, March 23, 2010

Insured Trading

As I understand, a major overhaul of financial regulation is one of the next items on Obama's social agenda. The theme of the reforms is that greedy investors took unnecessary risks and that we need the oppressive weight of big government on business to prevent risk taking.

The actual history of business is that risk taking leads to innovation which leads to better products and a higher quality of life.

I reject the partisan theme that risk taking is the problem. The question is the form of the risk taking.

A little known fact is that, for the last decade, the financial markets have been influenced by a little known 10,000 page piece of legislation passed in the lame duck session of the Clinton Administration called "The Securities Modernization Act of 2000."

This 10,000 page regulation is often called "deregulation." The regulation creates a slew of derivatives dreamed up in the University that were supposed to help banks and hedge funds control their risks.

The goal of these derivatives was to create a paradigm in which large banks and hedge funds could hedge their investments and essentially insure their trading.

Many of the mathematical formulas for trading came directly from the insurance industry as people hoped to manage investment risks in the same way that they managed physical risks.

The new dergulation-regulations essentially created an environment where investors thought they could insure there lending and trades.

Please note, the mathetical formulas and regulations designed to let large investors hedge against market forces are inherently anti-market.


What happened in reality is that the investors created a great deal of financial fluff and hot air as they traded abstractions like credit default swaps.

As there was no real physical backing to the securities, the market went up in a puff of smoke.

The sad legacy of the 10,000 page regulation marketed to the financial communinity as "deregulation" is that pundits are able to project the failure of a set of inherenly anti-market regulations onto the free market.

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