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Criticisms & Misuses of
Derivatives
The history of the financial markets is filled long-term fundamental values. The profits from Opponents of derivatives claim that the very
with extreme ups and downs, which are often short-term trading are almost always taxed more benefits of derivatives (low cost, low capital
called bubbles and crashes. Bubbles occur when heavily than the profits from long-term trading, requirements, ease of going short) result in an
prices rise for a long time and appear to exceed clearly targeting and in some sense punishing excessive amount of speculative trading that
fundamental values. Crashes occur when prices speculators. Speculators are thought to engage in brings instability to the market. They argue that
fall rapidly. Although bubbles, if they truly price manipulation and to trade at extreme prices. speculators use large amount of leverage, thereby
exist, are troublesome, crashes are even more so All of this type of trading viewed more or less as subjecting themselves and their creditors to
because nearly everyone loses substantial wealth just a form of legalized gambling. substantial risk if markets do not move in their
in a crash. A crash is then typically followed by In most countries, gambling is a heavily regulated hoped for direction. Defaults by speculators can
a government study commissioned to find the industry. In the United States, only certain states then lead to defaults by their creditors, their
causes of the crash. In the last 30 years, almost permit private industry to offer gambling. Many creditors’ creditors, and so on. These effects can,
all such studies have implicated derivatives states operate gambling only through the public therefore, be systemic and reflect and epidemic
as having some role in causing the crash. Of sector in the form of state-run lotteries. Many contagion whereby instability can spread
course, because derivatives are widely used and people view derivatives trading as merely a form throughout the markets and an economy, if not the
involve a high degree of leverage, it is a given of legalized and uncontrolled gambling. entire world. Given that the governments often
threat they would be seen in a crash. It is unclear Yet there are notable differences between gambling end up bailing out some banks and insurance
whether derivatives are the real culprit or just the and speculation. Gambling typically benefits only companies, society has expressed concern that the
proverbial smoking gun used by someone to do a limited number of participants and does not risk managed with derivatives must be controlled.
something wrong. generally help society as a whole. Another criticism of derivatives is simply their
The two principle arguments against derivatives But derivatives trading brings extensive benefits complexity. Many derivatives are extremely
are that they are such speculative device what to financial markets, as explained earlier, and complex and require a high-level understanding
they effectively permit legalized gambling and thus does benefit society as a whole. In short, of mathematics. The financial industry employs
they destabilize the financial system. Let us look the benefits of derivatives are broad, whereas the many mathematicians, physicists, and computer
at these points more closely. benefits of gambling are narrow. scientists. This single fact has made many distrust
Speculation and Gambling Nonetheless, the argument that derivatives are derivatives and the people who work on them. It is
As noted earlier, derivatives are frequently used to a form of legalized gambling will continue to be unclear why this reason has tarnished the reputation
manage risk. In many contexts, this use involves made. Speculation and gambling are certainly both of the derivatives industry. Scientists work on
hedging or lying off risk. Naturally, for hedging forms of financial risk taking, so these arguments complex problems in medicine and engineering
to work, there must be speculators. Someone are not completely off base. But insurance without public distrust. One explanation probably
must accept the risk. Derivatives markets are companies speculate on loss claims, mutual funds lies in the fact that scientists create models of
unquestionably attractive to speculators. All the that invest in stocks speculate on the performance markets by suing scientific principles that often
benefits of derivatives draw speculators in large of companies, and entrepreneurs to up against fail. To a physicist modeling the movements of
numbers, and indeed they should. The more tremendous odds to speculate on their own ability celestial bodies, the science is reliable and the
speculators that participate in the market, the to create successful businesses. These so-called physicist is unlikely to misapply the science. The
cheaper it is for hedgers to lay off risk. These speculators are rarely criticized for engaging same science applied to financial markets is far
speculators take the form of hedge funds and in a form of legalized gambling, and indeed less reliable. Financial markets are driven by the
other professional traders who willingly accept entrepreneurs are praised as the backbone of the actions of people who are not as consistent as the
risk that others need to shed. In recent years, economy. Really, all investment is speculative. movements of celestial bodies. When financial
the rapid growth of these types of investors has So, why is speculation viewed as such a bad thing models fail to work as they should, the scientists
been alarming to some but almost surely has been by so many? The answer is unclear. are often blamed for either building models that
beneficial for all investors. Destabilization and Systemic Risk are too complex and unable to accurately capture
Unfortunately, the general image of speculators The arguments against speculation through financial reality misusing those models, such as
is not good one. Speculators are often thought derivatives often go a step further, claiming that using poor estimates of inputs. And derivatives,
to be short term traders who attempt to exploit it is not merely speculation or gambling peruse being so widely used and heavily leveraged, are
temporary inefficiencies, caring little about but rather that it has destabilizing consequences. frequently in the center of it all.
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