The Financial Times recently used the phrase “casino capitalism” in an article which is part of a series on the “future of capitalism.” This particular piece examined the Asian approach to capitalism. The dean of Singapore’s Lee Kuan School of Public Policy is quoted as saying Asians have added the following lessons to the capitalist mix – “…borrow in moderation, save in earnest, take care of the real economy, invest in productivity, focus on education.”

The “casino” phrase is relevant to American capitalism I think because of credit default swaps (CDS). I have been trying to think of a an analogy to describe swap agreements, and the closest I can get is to discuss the game of blackjack. If a dealer turns up an ace as the face card, you will be offered insurance against the dealer having a twenty-one at the price of up to one-half of your original bet. If the dealer has a blackjack, you lose your original bet (unless you also have a blackjack), and the net effect is that you break even (assuming you bet the full one-half bet for insurance). If the dealer does not have a blackjack, you lose the insurance and still have to play the original hand. In this sense, placing an insurance bet in blackjack is like entering into a hedging transaction.

But what if instead of buying insurance from the dealer you buy it from one of the other players at the table. And then what if the other player buys insurance from yet another player (a “counterparty”) to offset the possibility of having to pay you if the dealer has a blackjack. This is staring to look like a CDS.

Consider an investor that has lent money to a corporation. The investor may turn to Bank A and buy protection against a default on the part of the corporation by entering into a CDS. Bank A may then decide that it wants to “hedge” its exposure to your CDS by entering into another CDS with Bank B. And so it goes. Ultimately, there is only one “real” asset – the loan the investor has made to the corporation. But several parties have placed many bets on whether the loan gets repaid.

A hedging transaction is rather like buying a little insurance, and a CDS is a type of hedge. Suppose I invest $100 and stand to get $200 back if all goes well. Depending on my risk tolerance, I may let it ride, or I may buy “insurance” for $50 (a “hedge”). If the investment tanks, I get my $100 back from the insurance but am out the $50 for the cost of the insurance. I have limited my possible downside. Of course I’ve also reduced my possible profit as well.

Hedging began as a way of reducing price risk on agricultural products. The farmer who plants a crop now, would like to lock in a price that will be paid when the crops are taken to market. This is done by entering into a “futures contract.” These contracts are traded on the Chicago Mercantile Exchange which is described on their website as “…the world’s largest and most diverse derivatives exchange and clearinghouse.”

“Hedge funds” are actually limited investment partnserships which are exempt from registering with the Secutities and Exchange Commission and are part of what is called the “shadow banking” system. As an industry, hedge funds have grown from $35 billion in 1992, to $1.5 trillion in 2007. What that means is that investors have been moving a lot of money out of a regulated financial system into an unregluated system. We shall explore the shadows in a subsequent blog…