Gambling by Another Name; The Challenge of Purely Speculative Derivatives

Abstract:     
Derivatives contracts can be used to hedge pre-existing risks, but they can also be used to speculate. This Article focuses on derivatives contracts in which both counterparties are speculators. These “purely speculative derivatives (PSD) contracts” have become increasingly common over the last several years and have notably resulted in the transfer of many tens of billions of dollars from institutions that had invested in the US subprime housing market to a handful of speculators who foresaw the market’s collapse, as well as many billions of dollars in fees to PSD brokers.

PSD contracts are problematic. PSD contracts are less-than-zero-sum transactions which decrease social wealth and are economically irrational. PSD contracts also pose systemic risks to the economy, jeopardize corporate stakeholders, are used for undesirable regulatory arbitrage, and can increase moral hazard.

Despite claims by champions of derivatives, PSD contracts benefit society in only limited ways. They contribute somewhat to asset price discovery and may foster valuable financial innovation skills. The existence of PSD contracts also provides economic activity to financial industry intermediaries. It is imaginable that PSDs re-distribute wealth to those better able to invest it. Finally, some PSDs provide entertainment utility. However, these marginal benefits often come at the expense of alternative, more beneficial activities, and PSDs may decrease liquidity in the market for potential hedgers.

Since the social costs of PSD contracts outweigh their social benefits, PSD contracts, except when they are explicitly authorized because of their entertainment value or because of their price discovery function, should be void for public policy.

Number of Pages in PDF File: 64

Keywords: deriviative, finance, financial derivatives, sub prime, financial crisis, purely speculative derivatives, gamblin, insurance, credit default swaps, options, futures, homogenous expectations, Dodd-Frank Act, Wall Street Reform and Consumer Protection Act, CFTC, Mortgage-backed securities

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