Why banning derivatives? The idea that derivatives markets have a destabilizing effect on the financial system has been pointed out for years. The arguments of the derivatives' opponents are based on the belief that derivatives are excessively complex, opaque, unregulated, and used by investors who lack financial competence. Derivatives are also deemed to lead to excess volatility, bubbles, and extreme losses, which in certain cases can be lethal. As a result, many have called for banning derivatives from certain activities, including asset management. For instance, the latest UCITS VI consultation paper issued by the European Commission considers limiting the use of derivatives based on their level of complexity: "Do you see merit in distinguishing or limiting the scope of eligible derivatives based on the payoff of the derivative (e.g. plain vanilla vs. exotic derivatives)?"

In practice, derivatives are widely used in the asset management industry. According to a recent Morningstar survey, 27% of U.S. mutual funds reported at least one derivative holding. Mutual funds in Europe make even larger use of derivatives. In their large survey of French asset managers, Beber and Pérignon find that 52% of the surveyed funds use derivatives and these funds represent 65% of the total assets under management. Derivatives are vital tools for the asset management industry. Derivatives instruments allow mutual funds to implement risk management activities efficiently and with relatively low transaction costs. They also allow asset managers to take specific views on specific markets or asset classes, often for diversification purposes.

The researchers established that if derivatives use were not allowed, mutual funds could generally still perform these activities, but they would have to sustain much larger transaction and operational costs. Such costs could in many cases provide an incentive for investment funds not to perform these risk-management activities, leading to suboptimal risk/return profiles that would cost dearly to final investors. Furthermore, if derivatives were not allowed, the investable choice set for the final investor would be dramatically reduced. A ban on derivatives in asset management would be particularly harmful for smaller size asset managers, as they cannot rely on large economies of scale when implementing alternative risk management strategies.

The Professors conclude that banning derivative use in asset management would entail increases in transaction costs and suboptimal risk management strategies, which would both penalize the performance for the final investor. Such a derivative ban would not be justifiable with the usual arguments against derivatives, because these arguments do not appear to be valid in asset management.

Click here to access the study
https://studies2.hec.fr/jahia/webdav/site/hec/shared/sites/perignon/acces_anonyme/bp.pdf

About the authors:
Alessandro Beber is a Professor in Finance at Cass Business School, City University London, UK. Professor Beber conducts empirical and theoretical research in Finance. His current work focuses on liquidity and asset pricing, risk management, currency and fixed income markets, and financial econometrics.
Christophe Pérignon is an Associate Professor of Finance at HEC Paris, France and he holds the Deloitte - Société Générale Chair in Energy and Finance. His areas of research are derivatives markets, financial risk management, and the regulation of financial markets.