In his latest FT column Professor John Kay discusses insurance and gambling. To a degree, the distinction is legal. An insurance contract is only valid if I have an ‘insurable interest’ – a risk of personal loss – in the event insured. If I am not exposed to the loss stated in the contract, it is treated as gambling: neither insurance nor a contract. Gambling agreements are not enforceable in law. So I can insure my house, but I can only bet on your house going up in flames.
Kay argues that nearly all use of credit default swaps (or CDSs) is gambling, and that this is highly damaging. He doesn’t extend the argument to other derivative instruments, but it applies equally and feeds into Kay's recommendation, made elsewhere, that if utility and other banking were separated, the utility banks’ use of derivatives should be restricted to those directly required to protect the utility business.
So, as a thought experiment, suppose I'm a UK utility bank and take your deposit and then place it in an Icelandic high-yield account. I buy a CDS from Goldman Sachs against the default of the Icelandic bank for the amount deposited. I then buy a CDS from Deutsche Bank against Goldman’s default and, just to be sure, a CDS from HSBC on the German government, which I assume will bail Deutsche out. I also need a currency swap because that contract is in euro, and while I'm at it, a little something in case the dollar moves against my Goldman exposure....
A few weeks later, the dollar has moved sharply against sterling so I unwind the dollar swap at a profit, judging it'll bounce back and that until then I’ll self-insure the dollar risk.
From the outside it looks as if many of these transactions were gambles, but can’t they all be justified in terms of managing the risk of the underlying business? Where can we draw a line and say Enough? Kay suggests it’s when people stop believing that the price has any relation to a risk transferred – in other words, when they’re just trading. This is a good start, though it will be hard to tell at that critical moment when the transaction takes place. But in the end, once we have finally separated the utilities from the casinos, is there a better answer than simply to stop these trades and require ALL the business risk held by utility banks to be carried ON the balance sheet?