I no longer think derivatives should just be banned. I now think they should be treated as gambling, and then banned.
That is, CFDs, CDOs, SCDOs, CPDOs, CDS and all the various other acronyms that might masquerade as financial instruments should be brought under the Interactive Gaming Act, 2001, which makes it an offence to offer “real money” online gambling to residents of Australia.
Sometimes financial derivatives are used by those who have a genuine trade or credit exposure to hedge or offset, but most of the time — the vast majority of the time in fact — they simply involve a bet, made by a punter, often online.
When they are not traded online, and are instead sold by liars masquerading as financial advisers, the “advisers” should be licensed as croupiers, and the “products” regulated as crap shoots and taxed accordingly.
The idea that derivatives are gambling and should be treated as such came to me this week while reading the judgment of Mr Justice Steven Rares in the case of Wingecarribee Shire Council versus Lehman Brothers Australia Ltd (in liquidation) — the class action on behalf of councils and charities that were sold synthetic collateralised debt obligations (SCDOs) by Lehman. The plaintiffs claimed they were not told the true nature of these instruments and sought $260 million from the liquidator of the collapsed investment bank.
An SCDO, by the way, is a ticket that pays out when a certain number of named companies go bust. It’s not based on anything but a list of names.
Last Friday Justice Rares found comprehensively in favour of the plaintiff, concluding that Lehman’s subsidiary, Grange Securities had engaged in “misleading and deceptive behaviour”.
In paragraph 1037 of the 400-page judgment, his honour says this: “The uncertainty of how to arrive at a present value for an SCDO is, in part, a reflection of the nature of the product. It is a ‘bet’ of the kind described by Mr Finkel in the passage of his report set out at  above. Thus, a transaction involving it, is the sale of such a bet … Bids represent a likely perception by one market participant of the lowest value that that person would place on the bet.”
“Mr Finkel” is James Finkel, the plaintiff’s expert witness and an expert in structured finance. He said, in paragraph 888, that an SCDO is “essentially a bet that the CDS (credit default swap) portfolio will only have a limited amount of net losses, which can be fully absorbed by others who have taken more junior slices [i.e. tranches] of risk (up to a specified loss threshold) on the portfolio of CDS”.
Exactly right. In fact all financial derivatives, including the still widely used credit default swaps, are mostly bets, not financial securities. There are hundreds of times as much money outstanding in CDS as there is in real debt underneath them. They should be treated as bets by the law and not regulated by the hopelessly inadequate laws and bodies that govern securities.
The Interactive Gaming Act was introduced to ban online “real money” gambling because it was impossible to protect punters. Casinos and bookmakers are separately regulated under state laws and taxed heavily. Some states tried to ban online wagering as well as online gaming to protect their tote monopolies, but the fact that the Northern Territory allowed online bookies drove a truck through those bans.
Now online bookies are off to the races, as it were, and busily fleecing punters of their hard earned, but at least they are kept honest and pay taxes.
The problem with regulating financial bets, aka derivatives, as if they are investment securities is not they are unregulated at the moment, but that the punters often don’t know they are gambling because they are dealing in the world of “securities”, not betting.
The Lehman CDOs, for example, were sold to the councils as “floating rate notes”, which, at a stretch, they were.
IMF Australia, the litigation funder supporting the Wingecarribee Shire and others, is now suing ABN Amro (now owned by Royal Bank of Scotland) plus Standard & Poor’s over another instrument called constant proportion debt obligations (CPDOs).
These were very complex things invented by ABN Amro in 2006, which provided 2% interest above Libor with AAA rating and were naturally hugely popular. It is alleged that S&P rated them AAA without doing any due diligence on the structures and in fact they should have been rated much lower.
Like SCDOs, CPPIs, CFDs etc, CPDOs were basically risky bets sold as safe investments to unsophisticated wholesale investors (councils and charities) and therefore without the need for prospectuses.
In 2007-08 the bets all lost and the chickens are now coming home to roost.
The reckoning for the lies told to investors by investment bankers in the bubble years leading up to 2007 will take many years to unfold and leave many of the victims well out of the money. Lehman’s victims in Australia, for example, will end up getting about 30 cents in the dollar, which is definitely better than a poke in the eye with a burnt CDO.
But to ensure it doesn’t happen again, governments need to find a way to distinguish between the use of financial derivatives for genuine hedging, and old-fashioned betting — and then regulate the latter accordingly.
*This article was first published at Business Spectator