The Fear Merchants: Behind Wall Street's Plan to Profit From Rocky Markets

Last Updated Nov 30, 2010 9:31 AM EST

Former Federal Reserve chief Paul Volcker famously questioned the value of financial innovation. For an object lesson in what he was talking about, look no further than the proliferation of products based on the Chicago Board Option Exchange's so-called Market Volatility Index.

The VIX, as it is called, charts how much investors are willing to pay for short-term options that track stocks on the S&P 500. Instead of charting prices, in other words, the index indicates levels of market volatility. Investors and traders use the VIX, which was developed in 1993 for the CBOE by Vanderbilt University finance prof Robert Whaley, to guard against -- and bet on -- future market swings.

As a result, the VIX has come to be known as the "fear index." When markets are turbulent, the index rises. That's because when volatility spikes, stock prices surge as investors demand higher rates of return. When volatility declines, the VIX tends to falls as investors accept lower returns.

And in fact the VIX works, if not flawlessly, then pretty well. In 1997, the index rose as the Dow plunged 555 points in October of that year during the Asian financial crisis. It proved similarly predictive a year later, when global markets went haywire amid fears that Russia might default on its debt. During the latest financial crisis, the VIX was also helpful in helping investors evaluate and hedge risk.

So what's the problem? It's that the VIX is spawning a host of related products that may have less to do with gauging volatility than increasing opportunities to speculate on the direction of the markets. According to the WSJ:

VIX clones have sprung up in Australia, Canada and India. There are now VIX-like measures in the crude-oil and gold markets. Soon, there will be a VIX each for corn and soybeans. The popularity of the index has fueled growth in futures and options just to bet on the VIX itself....

Some worry that the broad array of products and growth in trading of VIX options and futures could attract investors who don't fully understand the risks. The options can swing wildly in price as sentiment shifts, and investors could easily be caught off guard.

As the story notes, big Wall Street players such as Citigroup (C), Barclays (BCS) and Credit Suisse (CS) are creating complex, risky financial products, such as exchange-traded notes, that are linked to the VIX. Other banks are competing with the VIX itself. Bank of America (BAC) today announced the "Global Financial Stress Index," which the company says will help investors identify market risks "earlier and more accurately" than the VIX. Elsewhere, a California investment firm called AlphaShares offers something called the Chinese Volatility Index that, as the name suggests, gauges markets in China.

In most industries, there's nothing inherently wrong with a proliferation of new products. I like having a choice of toothbrushes, for instance. Yet finance isn't like other sectors -- as the circulatory system of the economy, its main task is to ensure that capital is allocated where it needs to go. To be effective, financial services must be transparent and simple to understand. When they're not, investors get confused. Innovations like the VIX quickly breed imitations that may not offer any significant competitive advantage over the original article.

That's how innovation works, of course. But do we really need a growing class of products that makes it easier not only to hedge against, but also to gamble on market volatility around the world? After all, such services are based on mathematical models, which as we've learned have a tendency to crap out in times of crisis.

More broadly, what value does the economy derive from commercializing fear? That's unclear, which is reason enough to be skeptical. It's the sort of innovation we can likely do without. The answer to radioactive markets isn't to design a better seismograph -- it's to reduce the chance of a meltdown. As Paul Woolley, a former banker and investor who now studies financial crises at the London School of Economics, recently told The New Yorker's John Cassidy:

"There was a presumption that financial innovation is socially valuable," Woolley said to me. "The first thing I discovered was that it wasn't backed by any empirical evidence. There's almost none."
Image from Wikimedia Commons, CC 2.0
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    Alain Sherter covers business and economic affairs for CBSNews.com.