A European super-regulator will have the final say over London's vast derivatives market and will acquire powers to limit the positions taken by banks and hedge funds, according to draft plans released by the European Commission. The proposals will also see traders facing capital charges if they choose to settle contracts outside the main exchanges. Over-the-counter trades will have to be cleared though a "central counterparty" so that regulators can keep tabs on overall risk. "A paradigm shift must take place away from the traditional view that derivatives are financial instruments for professional use, for which light-handed regulation was thought sufficient," said the draft. "Derivatives should be appropriately priced in relation to the systemic risk they entail, in order to avoid these risks being passed on to the taxpayers." It added: "Derivatives play a useful role in the economy. However, they also contributed to the financial turmoil by allowing leverage to increase and by interconnecting market participants, a fact which went unnoticed because of lack of market transparency." Insiders say European authorities were stunned to discover that French and German banks were massively exposed to US insurer AIG, creating the danger of an EU-wide crisis if AIG had been allowed to fail. – Telegraph

Dominant Social Theme: A necessary event.

Free-Market Analysis: We have pointed this out before and given this article, excerpted above, it is probably a good time to point out again that there is nothing wrong with derivatives. They are an inevitable evolution of the marketplace based on the computer power that is coming on line. To expect that derivatives would not make an entrance in today's financial world would be naïve.

Yet nothing is more arcane than finance to many people. They look at the plethora of instruments in the world today and wonder what the heck is going on. And then they walk quickly in the opposite direction with a queasy feeling that something is about to blow and often they are correct.

What would calm down the financial world is a good dose of market freedom and we believe it is on its way at some point. The current system tends to create arcane and fragile instruments because of the unholy interaction between regulation and finance. These interactions have been immensely complicated by computer power.

What is a stock but an artificial creation, a contract between buyer and seller? Were equity to have been invented today, absent regulatory interference, a stock might actually be traded routinely with other elements involved, especially elements having to do with time and maturity.

These combined instruments might have the effect of making the equity element less volatile. But try to suggest in today's regulatory environment that various instruments be blended and offered. You would have better luck flying to the moon using the NASA of today. Yet in a free-market this would be a viable choice, as would all sorts of other combined, complex instruments.

However ... let us not get carried away. Absent central bank monetary stimulation, a lot of the casino-like instruments that are traded nowadays probably would not have been invented in the first place. The tools are there, but it is the monetary euphorias that make them profitable. Absent monetary stimulation much of what passes for investing might not make a mark because people would not care.

We even question whether equity markets worldwide would be seen as viable or necessary absent great fiat money flows. It is the ability to print great amounts of money – so the public sees the lucrative nature of the stock market – that attracts people like flies to honey. But without money-printing, stock markets would not be nearly so attractive, in our opinion. Without money printing, debt markets would lose a great deal of product and interest. Without money printing ... well, you get the idea.

The whole invention of public markets is merely a regulatory conversation. Absent a regulatory declaration, markets would remain what they actually are – a private mechanism for buying and selling interests in opportunities. But just like commercial speech, those in government have found a way to create a whole new regulatory classification. Because an instrument is being traded by a certain amount of people with a certain net worth, it is suddenly "public" – and subject to a tremendous amount of regulatory and legal scrutiny that it would not otherwise obtain.

The system, not to put too fine a point on it, has built-in difficulties. It begins with raging central bank capital flows. The money roars out of central banks through commercial banks and finds its way into markets, most prominently stock markets. The market blows up like a puffer fish and begins to acquire jack-pot-like characteristics as well. Financial advisors jump to show clients in hindsight what most cannot ever hope to accomplish in real time – that the right analysis could have predicted what was to come. And thus "trading" is born as an activity for the middle class.

The point here is threefold: most instruments, absent regulation, would look a whole lot different than they do. Second, many instruments, absent regulation would offer elements of complexity in this computer age that they cannot because of regulatory turf wars, etc. Finally, many or most instruments including derivatives might be traded slowly or not at all were the financial environment to lose the super-charged aspect provided by central banking money flows.

Into this crazy world enter regulators once again to regulate "derivatives" – those bundles of instrumentalities that are tailored by mathematically adept individuals to squeeze further profit out of markets already over-stimulated by central bank money printing. These instruments no doubt would have been invented regardless, but it is the hyper-stimulation of fiat money that has sent them into orbit. Today, there is an estimated US$2 trillion in derivatives circulating the globe. The ONLY reason that these instruments are so popular – in our estimation – is because central banking provides the potential profitability.

So what to do? One could try to regulate computer power – and if enough derivative contracts break down, the regulators will try to do so in our opinion. Another thing one can do is to regulate derivatives themselves – which is what is going on now. A final alternative would be to do away with fiat money and central banking, which in our opinion would entirely fix the problem.

Of course the financial elite would rather be drawn and quartered than even imply that the central banking mechanism was responsible for the popularity of derivatives – though, in fact, central banking and fiat money flows are responsible for the entire modernity of what passes for 21st century "capitalism."

Don't like what's going on today? Don't blame Wall Street or the City serially – look to the unholy alliance between central banking commercial banking, investment banking and trading. And call it what it is, "mercantilism." The methodology whereby powerful entities leverage government laws – or make them up – in order to create profitable opportunities for themselves, their families and friends.

Derivatives are not bad, per se. They do not need "regulation." What needs to be done is to reduce or eliminate central banking. Without fiat-money the entire casino would be reduced, by necessity, to usefulness and the speculation that regulators decry – even as they support central banking globalization – would retreat significantly as would the volatility that supposedly makes so much regulation necessary.

It cannot be written enough (because few write it) that the elements of investing that most find distasteful are a direct result of super-energized money flows. Absent monetary mercantilism, the world might even now be enjoying the benefits of a private gold and silver monetary standard that would keep money stable and provide opportunities for real enrichment for all, and especially a burgeoning middle class.

Conclusion: The current system impoverishes the middle class, transfers incredible wealth to a handful of individuals and wealthy families and regularly destroys wide swaths of industries. This is NOT Schumpeter's creative destruction but something far worse. It is premeditated, hypocritical and, really, downright evil. And all the policing of "derivatives" won't change the bottom-line mechanism a bit. In fact, such regulatory complexity only further empowers the state and its mercantilist process, thus legitimizing further abuses of power and generally making the situation worse.

Latest Daily Bell Articles