View from City Road: Deriving some good out of US fear

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The Independent Online
The US Savings and Loans - the equivalent of building societies - went down the tube for dollars 300bn without anyone noticing one simple fact until they were bust. Borrowing short at floating rates and lending long at fixed rates is playing Russian roulette. The fact that lots of money was lent to crooks by other crooks simply made things worse.

So it is hardly surprising that a guilt-ridden US Congress, desperately trying to find the next financial black hole before the tax-paying public falls into it and blames politicians, has seized on the derivatives industry.

After all, some of the biggest players are commercial banks that benefit from government-backed deposit insurance. Beyond the potential of actual failure, the General Accounting Office report also questions whether it is right for banks to profit by speculating with tax-payers' insured money.

With all that mathematical mumbo-jumbo about butterfly spreads, delta gamma hedges and the famous Black-Scholes equation (come on, you must know the pioneering work on options pricing), derivatives are an obvious and tempting target.

Derivatives markets are hard to understand. They are highly likely to contain hidden risks of as yet unknown proportions. We should certainly be sceptical and refuse to take the word of experts on trust. Remember Hammersmith and Fulham and the other councils that blundered into derivatives markets?

The job of regulators nevertheless should not be allowed to extend beyond ensuring that the big operators have management systems that accurately measure their exposure day by day. If they still want to put their heads in a noose, that's their business.

If the GAO gets its way, we may be heading for a much more hands-on approach, with the regulators nannying the markets every step of the way - or more accurately, the US may be heading for that approach. For London's sake, let's hope they do it.

The Eurobond markets only came here because of restrictive tax and banking laws in the US. Investment bankers in the US were saying yesterday that the measures envisaged by the GAO would have a similar effect and drive derivatives trading out of New York into London. No wonder the Bank of England is so relaxed about it.