Derivatives have evolved from a tool used to manage risk to one that investors use to “game” the markets, according to Richard Bookstaber, author of the book, A Demon of Our Own Design, and a keynote speaker at November’s Investment Innovation Conference held in Bermuda. We interviewed him onsite and asked him about his views on financial innovation and how it has both benefits and harmed investors. “The derivatives markets have allowed investors to mold returns to meet their own investment objectives,” he said, adding that they have also generated a host of new risks. Despite their original uses as a risk management tool, derivatives have developed “complexities and strange nonlinearities” that have made them less useful for investors – and infinitely more risky.
In the future, however, Bookstaber says he believes Dodd-Frank will improve the landscape: “The legislation will restrict the ability of banks to create complex derivatives just for the sake of doing it,” he said. Central clearing will also “pull derivatives back from the edge” and eliminate what has become an “informational asymmetry between the banks that make derivatives and the investors that buy them.” Reduced complexity and increased standardization will eliminate the information “game” said Bookstaber and that will reduce innovation for the better in this space. Click on the image to watch the entire video.