We are living through extraordinary times. The unfolding of the credit crunch has already lasted over four years and many would argue that the situation is far from resolved. Sir Mervyn King, Governor of the Bank of England, has warned that a great number of Western economies will experience a “lost decade” and there are signs that even the booming Far East will not be immune.
Commentators and financial experts have offered a variety of opinions on the true cause of the crunch: too much financial deregulation; easy money from central banks; over-extended borrowing and spending by governments; and – always lurking in the background – derivatives. For many, the world of derivatives is shrouded in mystery, with complex mathematics and arcane jargon. From this viewpoint it is understandable that suspicion and distrust often surrounds the derivatives market.
In truth, derivatives are straightforward and can be simple (though they can also be made into extremely tortuous combinations). Far from being a risky and toxic product, derivatives are a valuable financial tool. So why are they associated with financial mayhem and labelled as dangerous by the likes of George Soros and Warren Buffet? The answer lies in how derivatives are used and the temptation they offer in two crucial areas: first, because of their potential to form complex structures it can be easy to create false accounting records (the exemplar being Enron); and second, since by their very nature they are ‘geared’ (in short, one doesn’t need the full 100 percent capital value to be able to create and trade them), it is possible to rack up large exposures and lose more money than the original investment.
Against this is the fact that many of us use derivatives in the course of our ordinary financial transactions – though we may not be aware of them. If you have ever taken out a mortgage and been given the option to switch between a fixed or a variable rate, you have purchased an interest rate option – a very common financial derivative. The mortgage lender, as seller, has the worry (but hopefully also the expertise) of managing the interest rate risks they have protected you from – and in return you have paid a small premium (almost certainly bundled into the overall rate you are being charged) to have that option. In the commercial world, derivatives are a vital part of allowing businesses to hedge (i.e. insure) their financial and commodity risks. A farmer looking to have a minimum guaranteed price for next year’s crop, a gold mine that wants to sell gold that has yet to be mined, or perhaps an importer looking to cap their foreign currency risks, can all make use of derivatives.
Such legitimate commercial transactions show the value of the derivatives markets. But what about the derivatives speculators that we read so much about? Although often decried, their role is vital. Whereas producers and mortgage borrowers are seeking to reduce their risk and exposure, there has to be a counterparty willing to take that risk with the skill to manage it through all future conditions until the deal expires. This is where the heavy-duty maths comes in. Lay people naturally tend to glaze over, but it is a vital component of pricing risk and of aiding the transference of risk between participants.
It can be shown that derivatives have a vitally important part to play in the smooth running of commercial markets and that they occupy an essential role in intermediating between the risk averse and those willing to take on the risks. Given this, how do we keep derivatives as the ‘good servant’ but avoid them becoming the ‘bad master’? Clearly the gearing effect is the most dangerous. Typically, one only has to lodge 10 percent of the contract value as cash to undertake a derivatives trade – and in some cases this may be even lower. This leads to margin trading that can be insufficiently backed by real wealth – and is vulnerable in adverse market conditions.
Many have argued that derivatives played a key role in the credit crunch – though more accurately they added a rocket-fuelled instrument that was not always fully understood by all participants, and certainly not completely controlled. The massive use of credit derivatives, which started as an insurance product but ended up being used as a highly speculative instrument, certainly played its part in accentuating the problems in the credit markets. The alphabet soup of various instruments – CDOs (collateralised debt obligations), CDSs (credit default swaps) and even CDOs-squared – proved to be a step too far for many participants who were frankly bamboozled by their exact nature and potential risks. And the sheer volume and complexity of related structured products, and inconsistency of the legislation, added to the problems. Such is the scale of the exposures that it is still too early to say that the worst is behind us.
Hopefully, global financial regulators are now fully aware of the risk issues surrounding derivatives. Major moves are under way to limit the gearing of such instruments and possibly to restrict traditional deposit-taking banks (as opposed to the more freewheeling investment banks) from using and trading these products.
Finding the sweet spot between the outright banning of derivatives (this would be economic nonsense) and total laissez-faire attitudes to financial products will always be a black art. We cannot eliminate risk in any walk of life, nor in most cases would it be desirable. The future of our economic well-being – and that of the derivatives markets – will be best served by careful, prudent and thoughtful regulation. Risk cannot be eliminated, only managed, and to do that we need to understand risk better, and learn to manage ourselves better as well.
