I thought that I would share my thoughts on a subject which is making headline news as I write.

The debate is around the breakup of the banks to protect the retail depositor from the high risk activities of investment banking, sometimes referred to as ‘Casino Banking’, which implies reckless gambling with our money. There appears to be serious tensions at Cabinet level within our Coalition Government and it will be interesting to see who gets their way!

Emotions can often cloud our judgement, so let’s take an objective look at one of the issues.

A key function in investment banking is the use of derivatives. These are financial instruments that are priced based on the future value of an underlying asset. Let me give an example.

Let’s say that you want to build a Villa in Spain (most unlikely at the moment!) and that this is going to cost you half a million Euros over the next six months. Assuming that you have to buy these Euros with sterling, it’s not rocket science to realise that you run a currency risk should the Euro appreciate against sterling. So what can you do?

1. If you can afford it, buy the Euros now and deposit them in a Euro
interest bearing account and earn some interest until they are needed.
2. Persuade the Spanish builder that you will pay in Sterling (which is
probably not feasible.)
3. Look to ‘insure’ against the possible rise in the value of the Euro
against sterling.

Three looks attractive so, you could enter into a contract now with a bank to sell you the Euros later when you need them, but at an exchange rate that is agreed now. This is called a forward exchange contract and it is a very simple type of derivative.

This transaction is a classic case of using a derivative to hedge against risk. But what about the situation where you aren’t buying a villa at all? Could you still enter into this derivative transaction and, if yes, why?

The answer is “yes” for the reason that you want to gamble on the future value of the Euro against sterling. In simple terms you sell the Euros later for a profit, but you run the very real risk of losing money.

So, derivatives can been used to hedge risk and speculate (or gamble). The “villa” is a very simple example, but if you can imagine a world of very complex derivatives being traded often using borrowed money for speculation, then you can begin to understand where the terms ‘Casino Banking’ comes from!

My own view is that there is merit in the argument that there is far too much speculation in derivatives, often by Hedge Funds, and although it is unrealistic to expect such practices to cease, I do think that their use should be curbed by, if necessary, Government action. It will be interesting to hear the views of others!