Way back in 2002, Warren Buffett called derivatives “financial weapons of mass destruction” -- a moniker that stuck like glue after the 2008 crisis, which many blamed on financial engineered products like collateralized default obligations (CDOs).
But what if Warren Buffett was wrong? What if derivatives are actually a force for good?
That is the guiding philosophy of Dr. Richard Sandor, CEO of Environmental Financial Products and author of Good Derivatives.
“The positives are [derivatives] can be used to help allocate and take price risk out of everything from corn to cattle to stock,” Sandor tells me in the accompanying video, taped at last week’s TEDxWallStreet event. “There are good derivatives that are self regulating [such as] interest rate swaps and currency forwards.”
Buffett was wrong with his 'WMD' call because he didn’t make a distinction between regulated – a.k.a. ‘good’ derivatives – and unregulated derivatives which are “opaque, have no price discovery and done with bilateral deals that could case systemic credit risk,” according to Sandor.
Indeed, Buffett knows this and is no stranger to derivatives: The equity index options Buffett sold in 2008 generated $2.1 billion in profits for Berkshire Hathaway in the first nine months of 2013, while the firm lost $61 million on credit default swaps and various interest rate and currency swaps.
As Sandor alludes, it was the unrelated CDOs – particularly those linked to mortgage-backed securities – that were at the heart of the financial crisis in 2008. There were 77 futures and options exchanges in 35 countries that required no bailouts after the credit bubble burst, he says, noting they trafficked in regulated, aka “good” derivatives vs. the bespoke deals made between financial firms without any oversight.
Sandor -- who has been called “the father of financial futures” and served on the boards of the Chicago Board of Trade (CBOT), the Chicago Mercantile Exchange (CME) and IntercontinentalExchange (ICE) (among others) before founding the Climate Exchange PLC (CLE) family of companies -- is a true believer in the power of markets. Yet he vehemently disagrees with the conventional Wall Street view that regulating derivatives will stymie innovation and flow of capital.
“I’ve been working for exchanges for 41 years,” he says. “I do not think regulation is incompatible with an efficient market. I think [derivatives] promote efficiencies.”