Derivatives such as options, swaps and futures that are used to hedge risk – and amplify market bets – have received arguably more than their fair share of abuse down the years. Sometimes complex, their reputation has been hit by assumptions that they are part of a “casino” economy and do not serve a valuable economic role. A few years ago, Adair Turner, the former head of the Financial Services Authority, the old UK regulator, branded much of this activity as "socially useless".

If that is true, what happens for asset managers and clients if derivatives are banned? Two academics, Alessandro Beber, Finance professor at London's HEC Paris, have made a “what-if?” analysis of the potential consequences. Their study describes what an economy without derivatives would look like, with an  emphasis on the asset management industry.

They found that under a bank mutual funds could generally still engage in the diversification and other moves undertaken via derivatives, but this would be most costly to do, in some cases putting investors at more risk than would otherwise be the case.

“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,” a statement from the academics said.

“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,” it said.

Their findings are unlikely to silence debate, since derivatives’ supposed role in making markets more volatile has been a staple of criticism for years. Instruments such as credit default swaps, the use of which has surged with the development of a “shadow banking” system, encouraged by capital regulations and associated developments, are sometimes attacked for their role in the sub-prime mortgage debacle. (Arguably, central banks such as the US Federal Reserve, and government incentives towards lax lending, are more fundamental drivers of the problem.)

“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,” the statement said.

Despite all the criticisms, derivatives are widely used in the asset management industry. A recent Morningstar survey found that 27 per cent of US mutual funds reported at least one derivative holding. Mutual funds in Europe make even larger use of derivatives. Some 52 per cent of the surveyed funds in France use derivatives and these funds represent 65 per cent 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 statement said.

The debate is likely to endure.