Behavioral Polemics In times of crisis, society develops a need for a theory of the crisis itself. That is, there must be a set of logically interconnected ideas that explains what happened before, what is happening now, and what will happen afterward. This is a laudable instinct, since once we can explain what brought us here, we can agree to not do it again. In the narrative of our current crisis, we as a society have forsaken the need for a coherent theory of events and have settled for a confused and hazy mythology inspired by the very real suffering of millions and the fear of more suffering to come. Like many other mythologies, its development was organic. Along the course of its development, the collective thinking of millions hashed together a cast of demons, sages, and saviors. Bombarded with images, sounds, and stories of calamity, we embarked on a psychological witch hunt, succumbing to the primal need to identify and destroy the cause of our suffering. Somehow, the derivatives market made the cast of demons in this mythology. And it seems that even some of the sharper tools in the box believe, in my opinion without any real theoretical basis, that the derivatives market has earned its place in that cast.
A Tall Order That Came Up Short In a recent Financial Times article, George Soros explained his own theory of the crisis. While certainly less mythological than most others, it is still theoretically unsound and factually inaccurate in several respects. In this article I take issue only with his treatment of derivatives. I happen to agree with many of his opinions on the Efficient Market Hypothesis and in a limited sense, what he calls “reflexivity,” which holds that a market price is not only a reflection of fundamentals but can also affect fundamentals.
Soros begins his argument by explaining how the risks of shorting a stock differ from the risks of owning a stock. Although there are other ways to short stock, let’s assume that we are talking about the method that involves borrowing stock, selling it, and then repurchasing the stock (hopefully at a lower price) and delivering it to the lender. Soros correctly points out that by shorting a stock, you leave yourself exposed to an effectively unlimited amount of risk, since the stock price could rise to arbitrarily high levels (back when those things used to happen), and you would be responsible for going out to the market, repurchasing it, and delivering it to the original lender, leaving you on the hook for the difference between the sale price and the repurchase price. He says that this means that ownership of stock and shorting a stock have “asymmetrical” risks. He then states that this asymmetry “serves to discourage the short selling of stocks.” While that statement is a bit unclear and incomplete, I get what he’s trying to say, and I can live with that.
He then incorrectly claims that shorting a bond through credit default swaps creates similar “asymmetrical” risks between buying protection and selling protection. He states that protection buyers have “unlimited profit potential” while protection sellers have “unlimited risks”. That is categorically false. Those who read my blog often know that the maximum risk exposure of a protection seller is capped at the notional amount of the CDS, which also limits the maximum reward of the protection buyer. Without the jargon, this means that both sides agree to the amount of protection bought at the outset of the contract. The protection seller never has to pay more than that amount and the protection buyer will never receive more than that amount. Thus, both sides of a CDS have a cap to the amount of credit risk they are exposed to.
This pulls the cornerstone out of Soros’ argument that CDSs over incentivize buying protection. There may be other arguments to that effect, though I doubt it given the bilateral nature of the contracts and the rule of no free lunch. In any case, his is certainly not one of those arguments.
– Betting On Failure Soros then argues that both the shorting of stock and the buying of protection through CDSs contributed to a lack of confidence, by lowering the price of stocks and raising the cost of protection respectively, each of which accelerated the demise of several institutions. This second argument is much more difficult to debunk as a practical matter. But that doesn’t imply that it is sound. The validity of this argument, and its inverse, depend on which occurred first: the lack of confidence or the shorting/protection buying. My instinct is that we may never know.
Moreover, the cyclical self-fulfilling dynamic that Soros is alluding to can be created without derivatives, shorting, or any of those fancy techniques: see e.g., bank runs. Whenever the dynamic running a market is a high level of demand for short term capital (which is what occurs during a liquidity crisis) coupled with the fear that you will be the last to exit a market, prices will plummet. This is because each participant has an incentive to maximize the short term value of its assets. And each participant knows that if it doesn’t convert its assets to cash or other low risk short term assets, the collective selling of others will erode the value of any assets that it doesn’t sell. So, even if a given participant doesn’t want to sell and values its assets at a price that is higher than the current market price, it will sell anyway if it needs capital in the short term.
Note that this logic creates an exception to the EMH. That is, when there is insufficient short term capital, there isn’t enough available cash to bring prices back up to efficient levels. This logic also explains the recent mad rush into short term Treasuries.
In short, even if Soros is correct that short selling and protection buying exacerbate self fulfilling market dynamics, which I doubt, they can occur anyway.
Originally published at Derivative Dribble and reproduced here with the author’s permission.