Why the Derivatives Market Will Surpass the Stock Market

After the financial crisis of 2007-08, and now the ongoing sovereign debt crisis, the derivatives market will, for many, live in infamy. Mortgage-related derivatives have pretty much disappeared, although many old ones continue to bedevil the banking system. Derivatives products for governments have been suddenly thrust into the spotlight by the sovereign debt crisis, and it's likely that these products will lose popularity as a result of their newly-found notoriety.

But the derivatives markets will live on, and mostly likely thrive, because the heat is on in the stock markets. Today, the SEC placed controversial limitations on short selling. If a stock's price drops 10% during a trading day, short selling will be permitted only if the national best bid price for the stock rises. This limitation will continue for the rest of the trading day and the following trading day. A number of hedge funds, including some that are known to focus on short selling and others not, opposed this restriction. So did at least one large bank, Goldman Sachs, which earns a lot of profits from proprietary trading.

The fact that professional traders opposed the short selling ban indicates that the prospects for the derivatives market are good. If the pros can't short sell stocks, they'll look for derivatives contracts that accomplish the economic equivalent. Indeed, a big bank like Goldman might take the lead in developing such contracts. An important reason why derivatives were so central to the growth of the mortgage market is that the lack of regulation of mortgage-related derivatives allowed the big banks to develop products and ways of doing business that were highly profitable (at least in the short run, but that's what matters for determining executive bonuses). There is considerable demand in the markets for the ability to sell short. The only question is what alternatives could be created to circumvent the new short selling restrictions.

The obvious stratagem would be to create a derivative in the nature of a single stock futures contract or a similar forward contract for delivery of the stock. Any such contract would presumably not be listed on a U.S. commodities exchange (the point is to avoid regulation), but would be traded over-the-counter. If necessary, it could be transacted overseas, in a friendly regulatory environment where the government didn't necessarily coordinately closely with U.S. regulators. If the firm offering such a derivative wanted to cover its exposure, it could itself trade in this friendly environment to hedge the customer contracts it sells, and just about no one would know the better.

Then again, the firm offering the derivatives equivalent of a short sale might not want to cover its exposure. The big money in proprietary trading comes from making one-sided bets in markets where prices are volatile. The day-to-day humdrum of market making in a stable market is like operating a grocery store--you make pennies at a time if you make pennies at all. If a firm thought itself skilled at making proprietary bets, it might take on unhedged exposure in the hope of hitting a home run. Sometimes, these bets pay off, and the temptation will be there in a world where the size of one's bonus establishes one's social standing. Without regulators around to frown about undue risk, temptation may triumph, as it did in the mortgage derivatives market.

Either way, the new short sale restrictions will hinder the small, individual investor trading a few tens of thousands of dollars in an online brokerage account. But the big boys with financial muscle will further the evolution of the derivatives market.

Another sign that the derivatives market is destined for growth is the news story that emerged in late January reporting that the exchanges are thinking about asking the SEC for authority to price quotes and transactions in increments less than a penny. See http://www.reuters.com/article/idUSTRE60P4PQ20100126. Apparently, alternative tradings systems like the so-called dark pools are pricing in sub-penny increments, and the exchanges are thinking they might need to meet the competition. The problem will be that the bid-ask spread (the difference between the bid price at which investors sell stocks and the ask price at which they buy stocks) will shrink when sub-penny prices are used. The bid-ask spread approximates the profit potential for brokerage and specialist firms making markets. As it shrinks, the profitability of the stocks business will diminish as well. Big bonus mania will push the financial firms toward the derivatives markets, where opacity is king and bid-ask spreads are indeterminate from the customer's standpoint (or, as much as the traffic will bear, from the dealer's standpoint). For a real-life illustration of how opacity and big profits intertwine, see http://blogger.uncleleosden.com/2010/02/will-wall-street-get-pass-on.html.

If serious reform of derivatives regulation by the U.S. and other major economic powers was in progress, the blessings of transparency would spread across the derivatives market and stratagems to circumvent the short selling restrictions would be harder to develop. Furthermore, the expansion of the derivatives market that is rendered inevitable by the shrinking margins in the stocks business would be fairer to investors. But the prospects for meaningful reform have diminished as the stock market has partially recovered and Wall Street has mounted a relentless anti-regulatory lobbying campaign. That leaves unchecked a humongous loophole in the regulatory structure through which the big banks can shove investors' money into an opaque and ungoverned environment where, as with mortgage-backed and mortgage-related investments of the early and mid-2000s, another shadow banking system can evolve, bubble up and pop again.