When people have a permanent job and they receive a cash infusion like a bonus or a tax rebate, they tend to spend the money on the things they always wanted to have but were obliged to put off in favor of using the money for other priorities. But now that they have the money, their pent-up demands will remain pent-up no more.
Thus, to get out of our current economic predicament, which we all agree will happen when the consumers will start spending again, we need to work on a long term solution to the looming problem of unemployment while at the same time do something to immediately infuse cash into the pocket of the consumers or, if the situation requires, do a series of cash infusions.
And while we do all that, we must not neglect to do something just as important. We must try to understand what happened in the years past that got us into the current predicament, we must work on a measure to prevent similar things from happening again and we must weave the measure into our permanent solution.
Experience tells us that the moment cash is infused into the pocket of consumers, those who have a job will spend the cash right away while those who do not have a job may spend some of the money but only if they see the promise that a job will be coming their way soon. Otherwise they will save the money or reduce their debt.
And so, to counter the reluctance of this latter group, the plan to infuse money into the pocket of the consumers must be designed in such a way as to negate the opportunity to do anything but spend the money. This will stimulate the economy which will offer the unemployed themselves a way to participate in the creation of jobs and thus improve their own chance at finding one soon.
And the best way to accomplish all of this is to lower or suspend the value added tax (VAT) which is a tax originally designed to discourage consumption and encourage saving. Every country has a VAT in one form or another which it collects in one way or another. For example, in Canada it is called the Goods and Services Tax (GST) and it is imposed on the consumers with every purchase of goods that is made and every service that is rendered.
What is important here is to reduce or suspend the VAT not permanently but for a short period of time such as a month or two. And the reason for this is to let the consumers know they must not put off their purchases indefinitely or they will lose the opportunity to save some money.
At the end of the period, an assessment is made to determine what effect the move has had on stimulating the economy and, if need be, repeat it once or twice more. Conditions may also be attached to the scheme such as the lowering or the suspension of the VAT for only some classes of goods like those made locally but not the imports, or the purchase of cars but not the textiles and so on.
This move will result in the creation of a virtuous cycle which will start with the raising of the expectations that will lead to the increase in economic activities that will lead to the rise in the level of optimism and back to the high expectations again. And this in turn will do much to help establish the proper climate for creating the kind of high paying jobs that will outlive the economic cycle during which they were created.
By stimulating the economy for the short term and by putting down the foundation for the creation of high paying jobs in the long run, we would have created the climate for rejuvenating the economy which is what will help us face the challenges of the future. But the job will not have been completed without us doing one more thing. To understand this part, we turn our attention to the following.
Like a body that is invaded by a virus, economic bubbles form and they get pricked all the time sending shock waves throughout the financial system. In fact, the making of a bubble starts with what may be called a moral virus that sends the participants in the financial system into a delirious state of fantasy. And the more the body becomes infected the more resistant it becomes to accepting reality. The result is that the participants cling ever more strongly to the belief that everything is fine and that things will get even better. But the pricking of the bubble happens anyway, the shock wave begins to hurt and everyone asks: How did it happen?
Let that question remain a rhetorical one and let us do something that science fiction writers do all the time. Aiming to have a happy ending for the horror stories they write, the writers use a neat little trick. They make the hero of the story anticipate the horror that is about to hit the group - perhaps a crew on a spaceship or an expedition of scientists on a far off planet - and they get the hero to do something about it. The writers get the hero to prepare an antidote that will work against the disease even after everyone has gone mad and has become cut off from reality.
The hero does it by constructing a system that triggers itself automatically when the time comes. A computer or a robot warns the crew that everyone has been infected and instructs them to submit to treatment. If the warning is ignored and everyone goes mad and becomes cut off from reality, the antidote is administered automatically by spraying it through the ventilation system.
If we now look closely at the financial crisis that hit the world, we see the similarities with this story in that the madness began quietly, the people who warned about it were brushed aside and the madness steadily spread till it reached what may be termed a pornographic level. This is when the people in charge of the system were giving themselves and each other hundreds of millions of dollars in salaries, perks and bonuses while their pauper supporters stood on the side watching them and cheering, powered only by the fantasy that they too will someday be rewarded and become the new fat cats on the bloc and in the neighboring alleys.
We conclude from this observation that in the same way that science fiction writers do their thing to reach the desired happy ending, we must include in the solution to the current crisis a way to prevent it from happening again or, if it does, from reaching a disastrous ending. To do this we devise a method that will warn of consequences when we all get mad and fail to realize that someone making hundreds of millions of dollars for doing nothing more than push paper is financial pornography gone beyond what is acceptable. If the warning is ignored, a remedy is automatically administered by a pre-ordained legal order. But how can this be done in practice?
Data is now collected by various organizations to measure how the quintiles in a society do financially in relation to each other. A quintile is a fifth of something. In this case, the population of a country is divided into five equal parts worth 20% each of the total population. At the bottom there is the poorest quintile, at the top the richest one and then there is the other three quintiles situated in the middle and called the middle class.
What the organizations do is get the information from the tax department, crunch the numbers, analyze them and publish the results. But the most that we have been getting so far in terms of reaction from anyone was a sense of mild astonishment that things were getting out of whack. What needs to be done instead is that the same data be brought to the attention of an authority that has the legal power to do something about it.
The authority will sound the alarm to the effect that something is getting out of balance and then identify by name the handful of culprits who are receiving pornographic levels of compensation. But because everyone who gets fabulously wealthy in a short period of time is not necessarily a financial pornographer, the matter must be looked into by regulators who will determine what is going on.
The regulators will need a test they can use to do the determination. Here is one idea. If the wealth is made by someone who is producing something tangible and not by pushing paper, the matter rests here. But if the wealth is given to someone who does no more than participate in the goings on of a financial enterprise, the compensation is declared an act of financial pornography, the money is disgorged and given back to the stakeholders from whom it was taken fraudulently or by navigation through the legal loopholes.
Merry Christmas and Happy New Year everybody. See you then.
Monday, December 15, 2008
Wednesday, December 10, 2008
Everyday A Christmas Day
She was so pretty I asked God for a favor but was not certain I had the right to ask for it at my age. We were both in our early teens though she may have been older than me by a few months, and according to Catholic teaching, flirting at this age was frowned upon if not forbidden altogether. Still, I prayed to God that if she became my friend I would go to the church that was adjacent to the school and pray every morning before going to class.
We lived in Djibouti, then a French colony now a city state at the Horn of Africa where foreigners came, stayed for a while and left. Consequently we had no time to forge long lasting friendships with each other but some people handled the breakup better than others. The pain was felt to some degree by the very young but their parents were always here to shower them with love and ease the pain, so the children adapted to the new situation in no time at all. As for the adults, they anticipated the breakup and had control over their own lives anyway, so they did not suffer much. Those who felt the sting of the breakup more than anyone were the tweens, as they are called today; those who were my age and Claire’s age, the girl I asked God to help me befriend.
What made things worse was that Claire’s father worked at the self contained military base called Le Heron where her family lived with a limited number of other civilian and military families. This situation made it so that the only time I could see her was at the beach which, thankfully, was frequented by people all year round given that Djibouti is situated near the Equator where it is warm enough to go to the beach and swim in December as readily as you do in July.
Up to that time I had not had the opportunity to speak to Claire but the family was new to Djibouti and being with her parents all the time, I could see that she had no friends; at least not a boy our age. And all I wanted from God was to engineer the opportunity for me to speak to her once after which I was confident we would become good friends.
I was a good swimmer and a diver too. In fact, a few years later, a coach I befriended at the Holiolido club in Heliopolis, Egypt thought I should train continuously to make it on the team that will be going to the Tokyo Olympics in 1964. This was not yet the Summer of 1960 and I was of the right age but it was too late for me to go to the Rome Olympics because I was not ready yet and because the selection of the Egyptian team had been made already by a committee that included my friend the coach.
Little did he or I know that my family will be preparing to go to Canada in 1964 and that I would have other things on my mind than to prepare for the Olympics. And so, when the time came, I said Sayonara to Tokyo and sang Arrivederci Roma. But I am getting ahead of myself so let me get back to Djibouti when I was still a tween and all I could think of was Claire whom I was certain had noticed my swimming and diving prowess.
What was exceptional about her was not her ability to swim or dive but the way she appeared when she went under the water. The picture I retain of her to this day is that of a perfectly sculpted body gliding through the water with blonde hair trailing over her neck and shoulders. The sight was magnificent and rewarding in itself but I wanted more. I wanted the opportunity to speak to her and be friends with her, and damn the reality that we shall have to break up someday as surely as night follows day.
Still, I dreamed of the day I shall speak to her and start a beautiful friendship, and the dream almost came true one evening when, for the first time, I saw Claire in a setting that was not the beach. In fact, it was very late at night, one Silent Night when I saw her as she sat beside her parents in church attending the midnight mass on Christmas Eve 1954.
But nothing happened that evening because there was no opportunity for us to bump into each other. And the coincidence was so ironic as this was the church where I promised God I would come to pray if He granted me my wish. Was He telling me something? Did I ask for the forbidden fruit? Was I supposed to promise I shall not try something naughty? I agonized and I prayed some more.
The beauty about living near the Equator is that on Christmas day when everybody wakes up around noon, it is time to go to the beach again and that’s where I went. Claire was there too with her parents who, on that day, left their Land Rover not out on the street as they always did but on the sand close to the beach which is something that people did when they felt too lazy to walk the few steps.
As I walked along the shore I saw a number of people, Claire among them, appear out of nowhere and frantically wave at me calling me a name I was never called before. They called me "Monsieur! Monsieur!" I looked around to see if there was an older someone standing nearby but I was the only one around. I stopped cold in my tracks wandering what happened to turn this Christmas day into the frantic scene I was witnessing.
They came close enough for Claire to say that her father lost his ring in the water and they wanted me to find it. The trouble was that I did not bring the mask on that day, and without it I could not see clearly under the water. I said to Claire I would have to go home and get the mask, a round trip that will take 15 minutes or so. She said not to worry because she had her mask in the car to which she started running without further ado.
In the meantime I went to the area where they said the ring was lost and asked everyone to stay away so as not to disturb the floor of the sea where they would bury the ring under the sand. Finally Claire came with the mask and I started to sweep the area going back and forth at about four feet above the floor of the sea, surfacing every minute or so to take air.
After a while I saw something shine in the distance and I went for it. It was a gold ring which I was certain was the prize I had come for. I picked it up and came to the surface holding my arm way up in the air to signal to those on dry land that I found it. They cheered me and I went straight to Claire’s father and gave him the ring.
The man proved to be generous and said the ring was more valuable to him than the gold in it so I could ask him for anything. But a wave of emotions was sweeping me at the time, among them the feeling that I was rewarded already by the opportunity to talk to Claire. She was all I wanted and she was so close to me now that I said I did not want anything. I don’t know if he knew this but he turned my dream into a reality I could not dream of when he said I should go with Claire and have ice cream at the Bar du Soleil a few feet to the left of me where he has an account and Claire is known to the owner and his wife.
And this is when something happened that was beyond my ability to dream. As if the gates of Heaven had opened and showered me with all that is heavenly bliss, Claire grabbed my hand, squeezed it hard and started to pull me away to the right as if in a hurry to take me somewhere. We were not going to the bar for ice cream because she had something better in mind; she wanted to take the mask to the car and that’s where we went.
We got there, sat inside the car and talked for a few seconds. Wasting no time, she asked me if I ever kissed a girl and I said no, I never did. She said she never kissed a boy either, and I wondered if this was an invitation. She took my hand and I mustered the courage to kiss her on the cheek. I felt her face warm up and I went for the lips where I kissed her for two seconds. And this was long enough for me to discover that the lips were more delicious than anything I ever tasted before; even more delicious than ice cream. I knew Claire felt the same way too because I could see the expression on her face but we decided it was time to go for the ice cream anyway and so we did.
For a few months after that we saw each other almost on a regular basis and forged a relationship centered around the beach and the activities there. In the meantime I kept my promise to God and went to church two or three mornings in a row but found a new excuse every day after that to go to class without making the detour to the church. It is a good thing I did not include in my promise to God how many times I would pray if He granted me the wish.
Then came the day I dreaded the most; the day when Claire and her parents disappeared from the scene. I went to the bar and asked if they knew what happened to the family. They said the father was summoned back to France, and the family left in a hurry; something about implementing the Geneva Accord regarding the defeat at Dien Bien Phu. I never saw Claire again or heard from her. Gosh, I hate those stupid wars and the people who love them.
Once in a while on Christmas day I remember Claire and my first kiss, and I wonder if she too remembers that wonderful day in her father’s car. At times I remember her even when it is not Christmas and feel like it is Christmas again because I learned over the years that I can make everyday a Christmas day by recalling the few moments that gave me a lifetime of joyous memories.
Merry Christmas, Claire wherever you are.
We lived in Djibouti, then a French colony now a city state at the Horn of Africa where foreigners came, stayed for a while and left. Consequently we had no time to forge long lasting friendships with each other but some people handled the breakup better than others. The pain was felt to some degree by the very young but their parents were always here to shower them with love and ease the pain, so the children adapted to the new situation in no time at all. As for the adults, they anticipated the breakup and had control over their own lives anyway, so they did not suffer much. Those who felt the sting of the breakup more than anyone were the tweens, as they are called today; those who were my age and Claire’s age, the girl I asked God to help me befriend.
What made things worse was that Claire’s father worked at the self contained military base called Le Heron where her family lived with a limited number of other civilian and military families. This situation made it so that the only time I could see her was at the beach which, thankfully, was frequented by people all year round given that Djibouti is situated near the Equator where it is warm enough to go to the beach and swim in December as readily as you do in July.
Up to that time I had not had the opportunity to speak to Claire but the family was new to Djibouti and being with her parents all the time, I could see that she had no friends; at least not a boy our age. And all I wanted from God was to engineer the opportunity for me to speak to her once after which I was confident we would become good friends.
I was a good swimmer and a diver too. In fact, a few years later, a coach I befriended at the Holiolido club in Heliopolis, Egypt thought I should train continuously to make it on the team that will be going to the Tokyo Olympics in 1964. This was not yet the Summer of 1960 and I was of the right age but it was too late for me to go to the Rome Olympics because I was not ready yet and because the selection of the Egyptian team had been made already by a committee that included my friend the coach.
Little did he or I know that my family will be preparing to go to Canada in 1964 and that I would have other things on my mind than to prepare for the Olympics. And so, when the time came, I said Sayonara to Tokyo and sang Arrivederci Roma. But I am getting ahead of myself so let me get back to Djibouti when I was still a tween and all I could think of was Claire whom I was certain had noticed my swimming and diving prowess.
What was exceptional about her was not her ability to swim or dive but the way she appeared when she went under the water. The picture I retain of her to this day is that of a perfectly sculpted body gliding through the water with blonde hair trailing over her neck and shoulders. The sight was magnificent and rewarding in itself but I wanted more. I wanted the opportunity to speak to her and be friends with her, and damn the reality that we shall have to break up someday as surely as night follows day.
Still, I dreamed of the day I shall speak to her and start a beautiful friendship, and the dream almost came true one evening when, for the first time, I saw Claire in a setting that was not the beach. In fact, it was very late at night, one Silent Night when I saw her as she sat beside her parents in church attending the midnight mass on Christmas Eve 1954.
But nothing happened that evening because there was no opportunity for us to bump into each other. And the coincidence was so ironic as this was the church where I promised God I would come to pray if He granted me my wish. Was He telling me something? Did I ask for the forbidden fruit? Was I supposed to promise I shall not try something naughty? I agonized and I prayed some more.
The beauty about living near the Equator is that on Christmas day when everybody wakes up around noon, it is time to go to the beach again and that’s where I went. Claire was there too with her parents who, on that day, left their Land Rover not out on the street as they always did but on the sand close to the beach which is something that people did when they felt too lazy to walk the few steps.
As I walked along the shore I saw a number of people, Claire among them, appear out of nowhere and frantically wave at me calling me a name I was never called before. They called me "Monsieur! Monsieur!" I looked around to see if there was an older someone standing nearby but I was the only one around. I stopped cold in my tracks wandering what happened to turn this Christmas day into the frantic scene I was witnessing.
They came close enough for Claire to say that her father lost his ring in the water and they wanted me to find it. The trouble was that I did not bring the mask on that day, and without it I could not see clearly under the water. I said to Claire I would have to go home and get the mask, a round trip that will take 15 minutes or so. She said not to worry because she had her mask in the car to which she started running without further ado.
In the meantime I went to the area where they said the ring was lost and asked everyone to stay away so as not to disturb the floor of the sea where they would bury the ring under the sand. Finally Claire came with the mask and I started to sweep the area going back and forth at about four feet above the floor of the sea, surfacing every minute or so to take air.
After a while I saw something shine in the distance and I went for it. It was a gold ring which I was certain was the prize I had come for. I picked it up and came to the surface holding my arm way up in the air to signal to those on dry land that I found it. They cheered me and I went straight to Claire’s father and gave him the ring.
The man proved to be generous and said the ring was more valuable to him than the gold in it so I could ask him for anything. But a wave of emotions was sweeping me at the time, among them the feeling that I was rewarded already by the opportunity to talk to Claire. She was all I wanted and she was so close to me now that I said I did not want anything. I don’t know if he knew this but he turned my dream into a reality I could not dream of when he said I should go with Claire and have ice cream at the Bar du Soleil a few feet to the left of me where he has an account and Claire is known to the owner and his wife.
And this is when something happened that was beyond my ability to dream. As if the gates of Heaven had opened and showered me with all that is heavenly bliss, Claire grabbed my hand, squeezed it hard and started to pull me away to the right as if in a hurry to take me somewhere. We were not going to the bar for ice cream because she had something better in mind; she wanted to take the mask to the car and that’s where we went.
We got there, sat inside the car and talked for a few seconds. Wasting no time, she asked me if I ever kissed a girl and I said no, I never did. She said she never kissed a boy either, and I wondered if this was an invitation. She took my hand and I mustered the courage to kiss her on the cheek. I felt her face warm up and I went for the lips where I kissed her for two seconds. And this was long enough for me to discover that the lips were more delicious than anything I ever tasted before; even more delicious than ice cream. I knew Claire felt the same way too because I could see the expression on her face but we decided it was time to go for the ice cream anyway and so we did.
For a few months after that we saw each other almost on a regular basis and forged a relationship centered around the beach and the activities there. In the meantime I kept my promise to God and went to church two or three mornings in a row but found a new excuse every day after that to go to class without making the detour to the church. It is a good thing I did not include in my promise to God how many times I would pray if He granted me the wish.
Then came the day I dreaded the most; the day when Claire and her parents disappeared from the scene. I went to the bar and asked if they knew what happened to the family. They said the father was summoned back to France, and the family left in a hurry; something about implementing the Geneva Accord regarding the defeat at Dien Bien Phu. I never saw Claire again or heard from her. Gosh, I hate those stupid wars and the people who love them.
Once in a while on Christmas day I remember Claire and my first kiss, and I wonder if she too remembers that wonderful day in her father’s car. At times I remember her even when it is not Christmas and feel like it is Christmas again because I learned over the years that I can make everyday a Christmas day by recalling the few moments that gave me a lifetime of joyous memories.
Merry Christmas, Claire wherever you are.
Thursday, December 4, 2008
To Avoid The Effect Of Toxic Derivatives
No one in his right mind will come out these days and say that all financial derivatives are good or that we should not take a critical look at them. On the contrary, most people would say that derivatives have hurt the financial system and they must be brought under scrutiny with the stated goal of bringing them under control so that the near meltdown of the system as we have experienced it lately will never happen again.
This discussion is not about a derivative that is now in use or one that has been discarded but about derivatives in general. It advocates the idea that the use of a derivative should be made only upon the filing of an application before an existing agency or one that would be set up for the purpose of regulating the use of new derivatives.
To this end, a description is made for a test to be used by regulators in order to evaluate the utility of a new derivative on one hand and the potential harm it may cause on the other. To make my point, I draw on my familiarity with the derivatives used in the stock market but I believe that the conclusions I reach would apply to other derivatives as well. If not, the test should be modified where possible to apply to the other spheres.
To visualize the situation we are dealing with here, the analogy comes to mind of a spectrum extending from the investment utility of a derivative at one extreme to its gambling potential at the other extreme. However, there exists between the two extremes all sorts of arguments as to the utility of a derivative which may not have much of a merit as an investment tool but has a secondary beneficial effect, mainly the addition of liquidity to the market. These arguments could be taken into account during the evaluation procedure as the regulators try to decide whether to allow an application or to reject it.
Where a derivative is most useful is when it allows a small investor to participate in the action with little money. There are now two instruments called the "Right" and the "Warrant" which fulfil such a function. During the remainder of this article I shall use the word warrant to mean either of the two. These instruments are now offered and distributed under some conditions but their use can be expanded especially in view of the fact that they are sometimes traded on the stock exchange where the conditions accompanying their offer are removed.
This is how the warrants come into being. When a company is confident about a project on which it intends to embark in the future but needs money to bankroll the project, it issues warrants allowing the existing shareholders to purchase new shares from the treasury at a fixed price and up to a specified date. For example, the shareholders would be given one warrant for every share they now hold. Under the terms of the deal, the shareholders can buy a new share from the company for one warrant and 10 dollars up to December 31 next year.
Now consider the following. If the shares are currently trading on the stock market at less than 10 dollars, nothing happens. But if the shares rise above 10 dollars, the holders of the warrants can use them to buy shares from the company at 10 dollars and sell them on the market at the ongoing higher price.
Sometimes the warrants themselves are allowed to trade on the stock market, and this is when the people who did not own the stock of the company to begin with can now own the warrants. If they wish, these people can hold the warrants until such time they are ready to buy the shares from the company at 10 dollars as long as they do so before the expiry date. However, if these people change their mind, they can sell the warrants and take the profit or the loss depending on what the warrants do on the market.
When trading on the stock market, the price of the warrants will vary with the price of the shares. For example, the warrants will trade at 1.25 dollars when the shares trade at 11.25 dollars because it takes one warrant to buy one share from the company at the fixed price of 10 dollars. Or, to take another example, the warrants will trade at 1.38 dollars if the shares trade at 11.38 dollars. In other words, the warrant will be worth the difference between the 10 dollars fixed price of the share and the current trading value on the market.
Thus, a small investor who has done his homework and has determined that the shares will rise to say, 14 dollars before the expiry date can buy the warrants at the modest price of say, 1.25 dollars and sell them later at 4 dollars. Or he can opt to buy the shares of the company at 10 dollars, and hold them for the long haul. If the investor is short of cash, he can borrow money to buy the shares and he will have no trouble finding a creditor willing to lend to him since the shares, which can be used as collateral, will be worth more than the amount he seeks.
Still, we must consider the possibility that the price of the shares will drop instead of rising and that it will stay down till past the expiry date of the warrants. In this case, the investor holding the warrants will have lost some or all of the 1.25 dollars per warrant he originally invested. This is a risk that most people can handle and are willing to take.
Instruments of this kind should be allowed to exist and their use expanded because they benefit everyone, and the risk to the participant is easy to understand. But if the derivatives get more complicated than that, the regulators must be inclined to reject them because the intent behind their creation is clearly to swindle the small investors through a shell game made to look like in an investment scheme.
The worst of these schemes involve the short sell of options such as the "bull call spread" which adds to the volatility of the stock market to begin with but more than that, it involves the supremely unethical and damaging principle of the short sell.
The short sell is a trick by which someone, call him Peter, sells a stock to a buyer, call him Paul, who does not necessarily know this is a short sell. Paul does not realize that Peter does not own the stock but is selling it anyway in the hope that the price will go down from say, 15 dollars to 12 dollars at which point Peter will become the buyer and buys back the stock to deliver to Paul.
It is even possible that Peter may buy the stock back from Paul who will have been disappointed by the performance of the stock not knowing that Peter created the condition for his disappointment. And so Peter now delivers the stock to Paul and pockets the 3 dollars per share he made in those demonic back-and-forth and back again trades.
What is horribly wrong with this scheme is that it is a principle of the market that every time a stock is sold, the transaction contributes to the lowering of the stock’s price. Thus, it is in the interest of the short sellers to keep selling the same stock even though they do not own it. Eventually the price comes down enough for them to buy it back and make a profit at the expense of the small investors who do not know what is going on behind their backs.
And the short sellers will have accomplished this feat not by adding liquidity to the market as they claim but by withdrawing liquidity from it. When they sell something they do not own, they not only drive the price down, they withdraw money from the market having added not one cent of their own to it. This is the opposite of what the regular buyers do which is to bring their own fresh money into the market and thus contribute to its rise.
There is another point to be made here. Nobody and no institution in this world are perfect all the time but this does not mean that when they stagger, someone can take advantage of their temporary weakness and contribute to their demise if not their death. For example, a bank robber cannot get away with saying that because the security system of the bank was deficient at some point, he had the right to rob it and must therefore be allowed to go free.
By the same token, the short sellers are to be regarded as pariahs and their practices banned even if they claim they are pointing out the deficiencies of the companies whose stock they sell short. These people do not do the public a favor but take advantage of a temporary situation to fleece the public. In this sense the short-sellers are equal to bank robbers and they should be treated morally and legally as such.
This is what the legislators should keep in mind when they write the legislation to regulate the use of derivatives. And this is what the regulators should keep in mind when they decide on a new application to allow or to reject the use of a derivative. Only when such a system is in place and functioning will we have a financial system that works according to principles that keep it healthy not according to the ill-conceived and improvised rules of its mad inmates as it does now.
This discussion is not about a derivative that is now in use or one that has been discarded but about derivatives in general. It advocates the idea that the use of a derivative should be made only upon the filing of an application before an existing agency or one that would be set up for the purpose of regulating the use of new derivatives.
To this end, a description is made for a test to be used by regulators in order to evaluate the utility of a new derivative on one hand and the potential harm it may cause on the other. To make my point, I draw on my familiarity with the derivatives used in the stock market but I believe that the conclusions I reach would apply to other derivatives as well. If not, the test should be modified where possible to apply to the other spheres.
To visualize the situation we are dealing with here, the analogy comes to mind of a spectrum extending from the investment utility of a derivative at one extreme to its gambling potential at the other extreme. However, there exists between the two extremes all sorts of arguments as to the utility of a derivative which may not have much of a merit as an investment tool but has a secondary beneficial effect, mainly the addition of liquidity to the market. These arguments could be taken into account during the evaluation procedure as the regulators try to decide whether to allow an application or to reject it.
Where a derivative is most useful is when it allows a small investor to participate in the action with little money. There are now two instruments called the "Right" and the "Warrant" which fulfil such a function. During the remainder of this article I shall use the word warrant to mean either of the two. These instruments are now offered and distributed under some conditions but their use can be expanded especially in view of the fact that they are sometimes traded on the stock exchange where the conditions accompanying their offer are removed.
This is how the warrants come into being. When a company is confident about a project on which it intends to embark in the future but needs money to bankroll the project, it issues warrants allowing the existing shareholders to purchase new shares from the treasury at a fixed price and up to a specified date. For example, the shareholders would be given one warrant for every share they now hold. Under the terms of the deal, the shareholders can buy a new share from the company for one warrant and 10 dollars up to December 31 next year.
Now consider the following. If the shares are currently trading on the stock market at less than 10 dollars, nothing happens. But if the shares rise above 10 dollars, the holders of the warrants can use them to buy shares from the company at 10 dollars and sell them on the market at the ongoing higher price.
Sometimes the warrants themselves are allowed to trade on the stock market, and this is when the people who did not own the stock of the company to begin with can now own the warrants. If they wish, these people can hold the warrants until such time they are ready to buy the shares from the company at 10 dollars as long as they do so before the expiry date. However, if these people change their mind, they can sell the warrants and take the profit or the loss depending on what the warrants do on the market.
When trading on the stock market, the price of the warrants will vary with the price of the shares. For example, the warrants will trade at 1.25 dollars when the shares trade at 11.25 dollars because it takes one warrant to buy one share from the company at the fixed price of 10 dollars. Or, to take another example, the warrants will trade at 1.38 dollars if the shares trade at 11.38 dollars. In other words, the warrant will be worth the difference between the 10 dollars fixed price of the share and the current trading value on the market.
Thus, a small investor who has done his homework and has determined that the shares will rise to say, 14 dollars before the expiry date can buy the warrants at the modest price of say, 1.25 dollars and sell them later at 4 dollars. Or he can opt to buy the shares of the company at 10 dollars, and hold them for the long haul. If the investor is short of cash, he can borrow money to buy the shares and he will have no trouble finding a creditor willing to lend to him since the shares, which can be used as collateral, will be worth more than the amount he seeks.
Still, we must consider the possibility that the price of the shares will drop instead of rising and that it will stay down till past the expiry date of the warrants. In this case, the investor holding the warrants will have lost some or all of the 1.25 dollars per warrant he originally invested. This is a risk that most people can handle and are willing to take.
Instruments of this kind should be allowed to exist and their use expanded because they benefit everyone, and the risk to the participant is easy to understand. But if the derivatives get more complicated than that, the regulators must be inclined to reject them because the intent behind their creation is clearly to swindle the small investors through a shell game made to look like in an investment scheme.
The worst of these schemes involve the short sell of options such as the "bull call spread" which adds to the volatility of the stock market to begin with but more than that, it involves the supremely unethical and damaging principle of the short sell.
The short sell is a trick by which someone, call him Peter, sells a stock to a buyer, call him Paul, who does not necessarily know this is a short sell. Paul does not realize that Peter does not own the stock but is selling it anyway in the hope that the price will go down from say, 15 dollars to 12 dollars at which point Peter will become the buyer and buys back the stock to deliver to Paul.
It is even possible that Peter may buy the stock back from Paul who will have been disappointed by the performance of the stock not knowing that Peter created the condition for his disappointment. And so Peter now delivers the stock to Paul and pockets the 3 dollars per share he made in those demonic back-and-forth and back again trades.
What is horribly wrong with this scheme is that it is a principle of the market that every time a stock is sold, the transaction contributes to the lowering of the stock’s price. Thus, it is in the interest of the short sellers to keep selling the same stock even though they do not own it. Eventually the price comes down enough for them to buy it back and make a profit at the expense of the small investors who do not know what is going on behind their backs.
And the short sellers will have accomplished this feat not by adding liquidity to the market as they claim but by withdrawing liquidity from it. When they sell something they do not own, they not only drive the price down, they withdraw money from the market having added not one cent of their own to it. This is the opposite of what the regular buyers do which is to bring their own fresh money into the market and thus contribute to its rise.
There is another point to be made here. Nobody and no institution in this world are perfect all the time but this does not mean that when they stagger, someone can take advantage of their temporary weakness and contribute to their demise if not their death. For example, a bank robber cannot get away with saying that because the security system of the bank was deficient at some point, he had the right to rob it and must therefore be allowed to go free.
By the same token, the short sellers are to be regarded as pariahs and their practices banned even if they claim they are pointing out the deficiencies of the companies whose stock they sell short. These people do not do the public a favor but take advantage of a temporary situation to fleece the public. In this sense the short-sellers are equal to bank robbers and they should be treated morally and legally as such.
This is what the legislators should keep in mind when they write the legislation to regulate the use of derivatives. And this is what the regulators should keep in mind when they decide on a new application to allow or to reject the use of a derivative. Only when such a system is in place and functioning will we have a financial system that works according to principles that keep it healthy not according to the ill-conceived and improvised rules of its mad inmates as it does now.
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