NYU Finance Professor Praises Derivatives

In a policy paper titled “In Defense of Derivatives: From Beer to the Financial Crisis,” New York University Clinical Professor of Finance Bruce Tuckman extolled the benefits of derivatives. “Policies that recognize the usefulness of derivatives and of holistic risk management and supervision,” he wrote, “will encourage businesses to use derivatives appropriately and, at the same time, reduce systemic risk.”

Professor Tuckman made the following arguments against several regulatory initiatives:

  • mandatory clearing may break apart bilateral portfolios that previously had comprised diversified combinations of liquid products (that now must be cleared) and illiquid products (that cannot be cleared);
  • imposing punitive margin requirements on uncleared derivatives might reduce derivatives volumes and risks, but also can increase nonderivative business risks; and
  • “required databases of derivatives trades and positions are unlikely to be useful in crisis prevention and management because they focus on a one-dimensional slice of firm and system-wide risks.”

He also recommended possible reforms that could reduce systemic risk without impairing the business uses of derivatives, including:

  • joint work by authorities and the industry to create common entity identifiers in order to improve firms’ and regulators’ abilities to manage holistic counterparty risk;
  • “a protocol to coordinate the liquidations of a failing firm’s most liquid derivatives and nonderivative claims”;
  • making the compression of over-the-counter derivatives positions a higher priority;
  • improving accounting norms in order to provide better holistic risk reporting, which would incorporate derivatives exposures; and
  • a narrowed safe harbor for derivatives to prevent the providers of illiquid leverage from being subsidized by their ability to circumvent the bankruptcy system.

Lofchie Comment: This excellent article should be read by anyone who is involved in financial regulation, whether at the political or regulatory level (or in the press).

Professor Tuckman is clear and to the point in his explanations as to (i) the benefits that derivatives provide (as well as their potential risks); (ii) the limited role that derivatives played in the financial crisis; and (iii) why a number of the measures taken by financial regulators to address systemic risk (e.g., mandatory central clearing) very likely did nothing or made the situation worse. (See recent article that included a statement by FDIC Vice Chair Thomas Hoenig, who is himself a proponent of mandatory central clearing, in which he effectively concluded that mandatory clearing was not effective in reducing systemic risk)..

If the economy is ever going to fully recover, then the people involved in its recovery must have a reasonable understanding of how financial products and markets work. Only on that basis is it possible to have a meaningful discussion about how to make the products and markets work better (or at least how not to undermine them). This article takes a significant step in that direction.