Derivative financial products have been around for a long time, and have been an influential force in the economy, for better or worse. Regardless of how you personally feel about them, there are legitimate arguments from economists both supporting and condemning them.
Recently, a survey of CPA financial executives revealed that the majority of financial experts are concerned about the valuation of derivatives and similar instruments. Nearly 70 percent of CPAs expect financial instruments to get more complex over the next 1-3 years, with only 1 percent believing they will decrease in complexity. Additionally, 55 percent are concerned about how derivatives are valued, pointing out a lack of transparency and inconsistent measuring. Though not surveyed, these fears and concerns are likely linked to a concern about the role of derivative financial instruments in the next financial crisis.
So where does the truth lie? Are derivative financial products a good thing for the economy at large, or do they end up doing more harm than good?
Derivatives in a Nutshell
For readers who aren’t familiar, let’s start with a basic definition of what derivatives are. A derivative financial product is typically a contract between a buyer and a seller that holds a value dependent on some external, underlying entity. In many cases, the derivative will provide value to a buyer or a seller based on the future performance of a given asset. In this way, trading derivative contracts serves as a secondary market, entirely dependent on the primary market.
For example, it’s possible to trade futures contracts, which contractually obligate a buyer and seller to exchange a given asset at a given price at some point in the future. Futures typically focus on commodities, like crude oil or sugar. So let’s say crude oil is currently trading at $60 a barrel. If a buyer believes that the price of oil will increase sharply in a month or two, they could buy a futures contract that stipulates they’ll buy 100 barrels of oil from a seller at $65 a barrel. A seller who believes oil prices will remain stable may take this contract, since it gives them a chance to sell oil for a higher-than-market price.
Futures are just one example of a derivative financial product. There are also options, forwards, swaps, and other variations, though they all follow the same basic formula. Different derivatives can also focus on different types of assets; instead of commodities, they may focus on stocks, or mortgages. For example, a commercial mortgage backed security (CMBS) loan allows you to borrow money with a first-position mortgage lien. You can learn more about commercial mortgage backed securities here.
The Benefits of Derivatives
So what are the benefits of these secondary derivative products?
First, they create more financial products for people to buy and sell, and provide more opportunities for people to make money. Without derivative products, if you believe an asset is about to plummet in price, there would be no direct way to make money off that fall. Instead, you’d have to wait to buy the product at its lowest point and wait for it to increase. With derivatives, you can directly profit from such an opportunity.
Second, derivatives give investors the opportunity to hedge their investments, and protect against risk. Selling futures contracts for a fixed price gives you a measure of guaranteed income from your commodities in the future, which can give you more stability and better peace of mind.
Also, derivatives serve a stabilizing role for the economy overall. It encourages more investors to participate in economic activity, and provides a kind of buffer that allows investors to mitigate losses. The price of an asset may also see mitigated jumps and drops, thanks to the number of derivative products riding on its performance. This is one reason why derivatives are being considered for cryptocurrency.
Criticism of Derivatives
However, there are some valid points of criticism against derivative products.
For starters, derivatives only hold created value; rather than trading a fractional share of ownership in a corporation or ownership of sugar, you’re trading a contract to buy a fractional share of ownership in a corporation or a fixed amount of sugar. This, hypothetically, adds no value to the economy because it isn’t tied to something tangible or functional.
Derivative trading is also seen as closer to gambling than investing, and many derivatives traders treat it this way intentionally. This can present extra risks for individual investors, compared to primary market products.
There’s also criticism of derivative products indirectly leading to the economic crisis of 2008. In this scenario, banks were making significant products from derivatives of mortgages; this incentivized them to sell more mortgages and overstate the quality of those mortgages. When people defaulted on those mortgages, it also caused the derivative market to be upturned, creating a ripple effect that eventually reached the global economy at large. This was likely due to deregulation, and not because of derivative products in general. However, if CPAs are concerned about the increasing complexity and decreasing transparency of derivatives, there may be legitimate cause for concern.
The Bottom Line
The science of economics is complex, to the point where economists seldom agree about anything. While there are many professionals who believe derivatives are a good and functional part of the economy, there are also critics who believe they cause more harm than good. Currently, the tide seems to be shifting in favor of CPAs who fear or worry about derivative financial products. If we don’t act to reduce complexity and improve transparency, they could lead to another economic crisis point.