property: Hernando de Soto on Derivatives & The Function of Publicly Available Property Documentation

One of the great economists of our time, Hernando de Soto, explains how markets and capitalism depend on public documentation, and how the publicly undocumented derivatives industry has thrown sand in the global system of capitalism:

If you think about it, everything of value we own travels on property paper. At the beginning of the decade there was about $100 trillion worth of property paper representing tangible goods such as land, buildings, and patents world-wide, and some $170 trillion representing ownership over such semiliquid assets as mortgages, stocks and bonds. Since then, however, aggressive financiers have manufactured what the Bank for International Settlements estimates to be $1 quadrillion worth of new derivatives (mortgage-backed securities, collateralized debt obligations, and credit default swaps) that have flooded the market.

These derivatives are the root of the credit crunch. Why? Unlike all other property paper, derivatives are not required by law to be recorded, continually tracked and tied to the assets they represent. Nobody knows precisely how many there are, where they are, and who is finally accountable for them. Thus, there is widespread fear that potential borrowers and recipients of capital with too many nonperforming derivatives will be unable to repay their loans. As trust in property paper breaks down it sets off a chain reaction, paralyzing credit and investment, which shrinks transactions and leads to a catastrophic drop in employment and in the value of everyone’s property.

Ever since humans started trading, lending and investing beyond the confines of the family and the tribe, we have depended on legally authenticated written statements to get the facts about things of value. Over the past 200 years, that legal authority has matured into a global consensus on the procedures, standards and principles required to document facts in a way that everyone can easily understand and trust.

The result is a formidable property system with rules and recording mechanisms that fix on paper the facts that allow us to hold, transfer, transform and use everything we own, from stocks to screenplays. The only paper representing an asset that is not centrally recorded, standardized and easily tracked are derivatives.

Property is much more than a body of norms. It is also a huge information system that processes raw data until it is transformed into facts that can be tested for truth, and thereby destroys the main catalysts of recessions and panics — ambiguity and opacity. To bring derivatives under the rule of law, governments should ensure that they conform to six longstanding procedures that guarantee the value and legitimacy of any kind of paper purporting to represent an asset …

In a related discussion, Mario Rizzo reminds everyone that valid asset pricing is dependent on a coherent regime of property right assignments.

Hernando de Soto explains the significance of secure, efficient, and public property rights documentation in his famous book The Mystery of Capitalism.

Friedrich Hayek discusses the importance of public records and financial statements in his book The Constitution of Liberty.  Modern markets depend on robust institutions, and nobody was more outspoken about this than Friedrich Hayek.

7 comments to property: Hernando de Soto on Derivatives & The Function of Publicly Available Property Documentation

  • geoih

    de Soto cuts to the heart of the matter with his usual genius.

  • Matt Dioguardi

    He finishes his editorial:
    “Financial institutions will have to serve society and fully report what they own and what they owe — just like the rest of us — so that we get the facts necessary to find our way out of the current maze. They must begin learning to put on paper statements about facts, instead of statements about statements.”

    Let me ask the following. Isn’t it in the company’s own interest to keep good records anyway? Shouldn’t each respective company *want* this information for themselves? And shouldn’t investors as well want this information?

    Why is that the government is the problem and the solution here? Perhaps over reliance on government is the greater problem. To a certain extent don’t the large financial institutions influence government to give them favorable treatment here? So as long as we rely on government to coerce people to give us good records, won’t this be open to manipulation?

    Am I misreading this?

  • T. Lee

    The “ambiguity and opacity” of derivatives may explain some of the formal features of the credit crisis, but that doesn’t get to the functional heart of the matter.

    What is the primary motivation for buying derivatives on such a large scale in the first place?

    Apparently, to find more stability in an inherently risky currency regime.

    Far from being the cause of economic crisis, the bulk of derivatives contracts are symptomatic of the market’s attempt to compensate for the monetary whims of central banks.

    Publishing derivatives contracts won’t do anything to fix the destabilizing influence of fiat money.

  • T. Lee

    From “Loose Money And the Roots Of the Crisis” by Judy Shelton:
    “No credit-default swap, no exotic derivative, can be structured without stipulating the monetary unit of account in which its value is calculated. Money is the medium of exchange — the measure, the standard, the store of value — which defines the very substance of the economic contract between buyer and seller. It is the basic element, the atom of financial matter. It is the money that is broken.”

  • Part of the issue with the recordation of derivatives is that technology (e-mail, text message and so on) has made the formation of legally-binding contracts very cheap and easy. Efforts to promote better documenation on derivatives (advocated by both de Soto and Geithner) will provoke massive campaigns to capture, archive and comprehend electronic financial records. See Details: http://legal-beagle.typepad.com/wrights_legal_beagle/2009/03/record-keeping-in-financial-markets-to-soar.html –Ben

  • T. Lee

    Hernando de Soto begins his article with a misunderstanding: “The Obama administration has finally come up with a plan to deal with the real cause of the credit crunch: the infamous “toxic assets” on bank balance sheets that have scared off investors and borrowers, clogging credit markets around the world.”

    Actually, the real cause of the credit crunch is the Fed — they forced interest rates below the natural rate of interest, fueling an unsustainable credit expansion boom that resulted in tremendous malinvestment and overconsumption, leading inevitably to a credit crunch. Roger W. Garrison explains how the Fed lost its way in this paper: “Interest-Rate Targeting During the Great Moderation: A Reappraisal”, http://www.cato.org/pubs/journal/cj29n1/cj29n1-14.pdf.

    Derivatives are now being demonized as inherently “toxic assets” in order to further the myth that unregulated capitalism is to blame for the financial crisis, details here: “The Myth that Laissez Faire Is Responsible for Our Present Crisis”, http://mises.org/story/3165

    One of the best articles that explains the economic crisis in essential terms is: “The Crisis in 10 Points” by Robert Stewart, http://mises.org/story/3263.

  • T. Lee

    In a disaster or force majeure scenario where it becomes impossible to perform under the terms of a contract, it doesn’t matter one bit how the contract is recorded. Under such conditions, it is not the contract that is “toxic”, it is the external force that is the origin of harm.

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