Gillian Tett, Assistant Editor, Financial Times
The dual role derivatives
The key thing to understand about derivatives is that they have two faces. On the one hand you can use derivatives to control risk, to insure yourself against things that might go wrong in the future, but you can also use derivatives to speculate, to gamble on how the future might look.
Now, in the early years, people tended to create derivatives and develop derivatives in order to allow themselves or their clients to try to insure themselves against negative things in the future. It was very much the risk mitigation aspect of derivatives that was being stressed. But then what happened was that people realised that in order to have risk mitigation tools, you need to have somebody who’s going to be on the other side of the trade and willing to take risk. You can't go out and insure your car against theft unless there’s somebody else out there who’s willing to make a bet on whether or not your car’s going to get stolen. And people started to realise that actually using derivatives to speculate could be a very powerful way to make business, and it was that speculation element that really took off.
Essentially the banking industry has two functions to it. On the one hand banking is about a utility function of pushing money around the economy to make the economy work, a bit like electricity or water or something like that, but at the same time governments in the West have assumed for the last few centuries that banking should also be a business; it’s a profit seeking enterprise. And obviously there is a temptation when you're handling money to use money to make more money, and the way the incentive structure is set up within banks, they are incentivised to keep making as much money as they can as fast as they can, and offering their clients whatever tools they want to make more money themselves. If electricity companies were paid or paid their managers per kW of energy that they pumped out, no matter how much demand there was for that energy, we probably would have all blown ourselves up or electrocuted ourselves up by now. But bankers basically have an incentive just to keep pumping out as much money or as much profit seeking products as they can.
The growth of risk taking
One of the ways that derivatives work is to allow people to think that they have insured themselves against the risk of bad things happening. So, in the case of credit derivatives, financial institutions were increasingly using credit derivatives to insure themselves against a chance of a loan going badly wrong, or a bond going wrong. And what that meant was that banks and other players started to think well hey, I've got insurance, I can make more loans. It’s a bit like wearing a seatbelt in a car and thinking that you can drive a lot faster because even if you crash you’ve got protection. And so there was actually a strong incentive for banks and other financial institutions to keep pumping out more and more and more loans with less concern about the potential risks because they thought they had insurance against those risks.
The role of London
London’s been an absolutely crucial centre for derivatives over the last decade or two. There’s a lot of reasons for that. One of them is that Europe, when it moved to the euro, had a need to find all types of new systems of financing for European companies, the launch of the euro if you like gave the system a shock and a jolt, which allowed people to embrace a lot more innovation than they had before. Another key factor though is that London is not just an international centre, but it’s traditionally had a regulatory regime which is pretty welcoming to innovation, and unlike America, which tends to operate with a very rules based system, London’s operated on more of a sort of principles based system, where the idea has generally been that you can innovate, you can be creative, you can cross boundaries and mix ideas more freely than in a system where you have to keep sort of ticking rules or jumping between boxes and employing armies of lawyers every time you move.
And of course from the late 1990s onwards, this light touch regulatory regime became even more entrenched and it became seen as a source of competitive advantage for the UK that we could attract a lot of creative financial activity to British shores that wasn’t going to America and wasn’t going to Continental Europe, but was coming to London and helping to boost the UK economy.
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