28 Feb 2010

How to regulate Derivatives

Warren Buffett famously described Derivatives as Weapons of 'Financial mass destruction' (2002 Letter to Shareholders of Berkshire Hathaway). While we think that this catchy phrase exaggerates the dangers of derivatives it has to be accepted that these contracts are essentially bets similar to futures contracts. As they are highly leveraged - in contrast to futures contracts there often is no margin at all - and no money may change hands when the initial contract is signed they are susceptible to outright fraud or abuse by overambitious traders and financiers. We would like to add to the debate by suggesting that all forms of derivatives are subject to meaningful margin requirements (including capital requirements in balance sheets of banks, insurance companies, corporations and public entities).

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