Financial Derivatives in the 2000′s like Thalidomide in 1950′s?

Remarks I made at IIM Cal’s International Finance Conference, Calcutta  Jan 10th, 2010 with India’s Finance Minister, Pranabh Mukherjee attending.

‘Whenever financial experts gather nowadays the talk inevitable veers to the financial industry meltdown of 2009 in the US and Europe. Was it greed on part of the market participants, was it a failure of the regulatory system, was it the compensation system for financial industry executives that lay at the bottom of this crisis which has created immense suffering for tens of thousands of ordinary people in the United States and Europe?
We have seen an outpouring of dozens of scholarly papers, many dozens of books and thousands of newspaper editorials trying to make sense of these events. Implicated in all of this are ‘derivatives’,mathematical abstractions. Even a savvy marlet player like Warren Buffet has called them weapons of mass destruction.

But do derivatives deserve this kind of demonization?

I draw your attention to a similar event inthe pharmaceutical industry in the 1950′s in the early days of the synthetic drugs era when a German company came up with a ‘wonder drug’ that supposedly cured coughs, cold, headaches and was also a tranquilizer, a pain killer and could also cure insomnia. It was soon a best seller in many countries. It was then also discovered that this wonder drug could also relieve morning sickness in pregnant women, so tens of thousands of pregnant women took to it.

Then reports started filtering in that pregnant women who took this drug were giving birth to babies with deformities: the feoutus would have fish-like flippers instead of arms and legs. Tens of thousands of children were born by the time alarm bells rang and sales of this wonder drug were halted.

This, of course, was Thalidomide.

There were many calls at that time for the ban of all further synthetic pharmaceutical innovations such as derivatives are now being demonized. Wiser counsel prevailed. An elaborate system of clinical trials was instituted, the scale and expertise of national level drug approval authorities like the US Food and Drug Administration was bolstered. The occasionally confliciting needs of Consumer protection and technical innovation were reconciled. The world has since then benefited enormously from an outpouring of synthetic pharmaceuticals.

The derivatives issue needs to be looked at in a similar light. If properly designed and tested and with the right regulatory system, derivatives could play as big a part in our lives as other financial innovations such as the metal coin or the paper currency note or Bills of Exchange have done.
Instead of demonizing the derivatives innovation, we should put in place testing facilities and regulatory systems which will allow mankind to benfit from this financial innovation.  Central to this new system of regulation of derivatives are expert and neutral bodies who can undertake stres testing of derivatives.

IIM Calcutta’s Financial Research and Trading Lab is one such facility which is ready to undertake such stress testing on behalf of regulatory authorities.

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