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.