Derivatives (huh, yeah). What are they good for?

Commenter Linda S, who has an exasperating habit of asking questions that I don't really know the answers to, asks regarding credit default swaps:

I ... have read articles that suggest that these swaps not only give people an incentive to drive a company into bankruptcy but that it provides a huge incentive to make sure the company is liquidated and not allowed to restructure. I am more familiar with equity options than credit swaps. Although equity derivatives can provide incentives for speculators to do things that aren't beneficial for society as a whole, I don't think they create these kinds of incentives to cause bankruptcy and liquidation. Maybe this is a broader question about whether all derivatives are inherently evil or whether they can be tamed by good regulation or in other words should certain instruments be outright banned? If so, which ones and why?

Economists have been defending derivatives at least since Adam Smith's day. Here's what Smith had to say about corn futures in The Wealth of Nations:

No trade deserves more the full protection of the law, and no trade requires it so much; because no trade is so much exposed to popular odium.

Smith's argument was that futures trading helped balance the supply and demand of corn across different regions and over time--thus easing shortages and preventing famines. And that has continued to be the main theoretical argument for derivatives of all stripes. They allow for risks to be shared by different people across time. That, and they provide incentives for traders to dig up useful information, which should make markets more efficient.

In the famous model of economic equilibrium devised by Kenneth Arrow and Gerard Debreu in the 1950s--and I'm a bit out of my league here because I'm no economist, but I'll slog onward anyway--the presence of securities that allowed one to bet on or insure against every possible economic outcome was essential to the attainment of equilibrium in the face of uncertainty about the future. In the 1970s, Arrow's student Stephen Ross was the first to suggest that maybe futures, options and other derivatives were the real-world equivalent of these theoretical "state securities." So the more derivatives, the better off we'd all be.

That's the theory. In terms of empirical research there have been gobs and gobs of studies examining whether the introduction of derivatives makes the underlying market (for corn, for onions, for stocks, for bonds) more or less volatile. Stewart Mayhew, who is now deputy chief economist of the SEC, put together a nice summary of this research in 2000 (pdf!). His conclusion:

The empirical evidence suggests that the introduction of derivatives does not destabilize the underlying market--either there is no effect or there is a decline in volatility--and that the introduction of derivatives tends to improve the liquidity and informativeness of markets.

There are a couple of issues with this. One is that a less-sympathetic reader could go through the studies Mayhew cites and conclude there just isn't decisive evidence either way. The other is that the bulk of the research done on the matter has been done using data from the past few decades. And that, as one Alan Greenspan pointed out earlier today, can be problematic:

In recent decades, a vast risk management and pricing system has evolved, combining the best insights of mathematicians and finance experts supported by major advances in computer and communications technology. A Nobel Prize was awarded for the discovery of the pricing model that underpins much of the advance in derivates markets. This modern risk management paradigm held sway for decades. The whole intellectual edifice, however, collapsed in the summer of last year because the data inputted into the risk management models generally covered only the past two decades, a period of euphoria. Had instead the models been fitted more appropriately to historic periods of stress, capital requirements would have been much higher and the financial world would be in far better shape today, in my judgment.

So Linda S, my first answer to your question is that I can't say with any kind of confidence whether derivatives are inherently evil or not, or which derivatives are the most evil (or good). But the great thing about the current financial meltdown is that we'll soon have much better data to help us make those judgments.