INTRODUCTION
DERIVATIVES SERVE an important and useful economic function, but they also pose several dangers to the stability of financial markets and the overall economy. They are often employed for the useful purpose of hedging and risk management, and this role becomes more important as financial markets grow more volatile. However, they can also be associated with massive market failings whose consequences can be tragic. Most remember the LTCM episode, when this major hedge fund’s derivative holdings imploded, nearly bringing down with them the global capital market as we know it.
As the name suggests, a derivative is a financial contract whose value is linked (“derived”) to the price of an underlying commodity, asset, rate, or index. Derivatives markets also serve to determine the prices of many assets and commodities and the economic value of nonmarket events such as the weather. However, they are also used for unproductive purposes such as avoiding taxation, outflanking regulations designed to make financial markets safe and sound, and manipulating accounting rules, credit ratings, and financial reports. Derivatives are also used to commit fraud and to manipulate markets.
Derivatives are powerful tools that can be used to hedge the risks normally associated with production, commerce, and finance. Derivatives facilitate risk management by allowing a person to reduce his exposure to certain kinds of risk by transferring those risks to another person who is more willing and able to bear such risks. Farmers use derivatives to hedge against a fall in the price of their crop before the crop can be harvested and brought to market. Banks use derivatives to reduce the risk that the short-term interest rates they pay to their depositors will rise above the fixed interest rate they earn on their loans and other assets. Utility companies can hedge the (typically volatile) price at which they purchase gas, oil, and other source fuels as well as the (also typically volatile) price at which they sell electrical power. International businesses hedge their foreign-exchange risk from trade and investment.
As a testament to their usefulness, derivatives have played a role in commerce and finance for thousands of years. Derivatives contracts have been found written on clay tablets from Mesopotamia that date to 1750 B.C. Aristotle mentioned an option type of derivative and how it was used for market manipulation in the fourth century B.C. (Politics, chapter 9). Derivatives trading on an exchange can be traced back to twelfth century Venice. In the early seventeenth century, futures and options were traded on stocks and commodities such as tulips in Amsterdam. The Japanese traded contracts similar to futures on warehouse receipts for rice in the eighteenth century. In the United States, forward and futures contracts have been formally traded on the Chicago Board of Trade since 1849.
Today, derivatives are traded in most parts of the world, and the size of these markets is enormous. Data for 2002 by the Bank of International Settlements puts the amount of outstanding derivatives in excess of $165 trillion and the trading volume on organized derivatives exchanges at $693 trillion. By comparison, the IMF’s figure for worldwide output, or GDP, was $32.1 trillion.
WHAT ARE DERIVATIVES?
As noted above, a derivative is a financial contract whose value is linked to the price of an underlying commodity, asset, rate, index, or the occurrence or magnitude of an event. The term “derivative” refers to how the price of these contracts is derived from the price the underlying item. Typical examples of derivatives include futures, forwards, swaps, and options, and these can be combined with traditional securities and loans in order to create structured securities which are also known as “hybrid instruments.”
The simplest and perhaps oldest form of a derivative is the forward contract. This is the obligation to buy (or sell) a certain quantity of a specific item at a certain price or rate at a specified time in the future. For example, a foreign-exchange forward contract requires party A to buy (and party B to sell) 1 million euros for U.S. dollars at $1.0865 per euro, say, a year from now. A forward rate agreement on interest rates requires party A to borrow (and party B to lend) $1 million for three months at a 2.85 percent annual rate beginning a year from now.
Futures contracts are like forwards, except that they are highly standardized. The futures contracts traded on most organized exchanges are so standardized that they are fungible—meaning that they are substitutable one for another. This fungibility facilitates trading and results in greater trading volume and market liquidity. This allows the buyer of a futures contract to extinguish his obligations by selling an identical contract instead of having to take delivery of the underlying item at the expiration of the contract. The public trading of futures in a transparent environment means that everyone can observe the market price throughout the trading day.
Swap contracts are one of the more recent innovations in derivatives contract design. The first currency swap contract was between the World Bank and IBM and began in August of 1981.1 The basic idea in a swap contract is that the counterparties agree to swap two different types of payments. A payment is either fixed or is designed to float according to an underlying interest rate, exchange rate, index, or the price of a security or commodity.
Take the “vanilla” interest rate swap as an example. This is a transaction structured so that one series of payments is based on a fixed interest rate and the other series is based on a floating interest rate such as LIBOR or a U.S. Treasury bill yield. Why would the two parties enter into such an agreement? One possible explanation has to do with different interest rate expectations: the party agreeing to pay off the variable interest rate loan must be expecting interest rates to be falling while that agreeing to pay the fixed interest rate must be worried that rates will be rising in the future.
A second example is a foreign-exchange swap that comprises two transactions; the first involves buying (or selling) a foreign currency at a specific exchange rate, and the second involves selling back that currency at another specific exchange rate. A foreign currency swap is structured so that one party makes a series of payments based on an interest rate in one currency and then receives a series of payments in another currency based on that currency’s interest rate. Here again, parties enter into such transactions because they need to hedge existing foreign exchange exposures or they have differing views about how the exchange rates will be moving in the future.
Consider an example of a foreign-exchange swap of a U.S. dollar for Mexican peso. A Mexican investor enters a swap to buy $100,000 with an exchange rate of $0.1000 per peso (thus paying 1,000,000 pesos). Simultaneously, the same investor commits to selling, in 180 days, the same $100,000 dollars (that is, buying pesos) but at an exchange rate of $0.0952 (thus receiving 1,050,000 pesos). Put differently, the investor is guaranteeing himself a 50,000 peso profit in six months!
Two questions arise from the above example. First, is this a risk-free trade in which the investor is guaranteed a profit? Of course not. While the investor is indeed making a profit in pesos, he may well be making a loss when the trade is denominated in dollars. For example say the actual exchange rate in six months turns out to be $0.08 instead of the contracted $0.095. In this case, the original investment, when valued in dollars, would actually be worth $80,000 rather than the original $100,000. In this event, the investor would have lost 20 percent.
SIDEBAR
Derivatives are traded in two kinds of markets: in exchanges and in over-the-counter markets. Exchange trading has been traditionally organized in “pits,” where trading occurs through “open outcry” of bids and offers. Pit trading is increasingly augmented and sometimes replaced by electronic trading systems that automatically match bids and offers.
OTC markets are organized along various lines. The first is called a “traditional” dealer market, the second is called an electronic brokering market, and the third is called a proprietary trading platform market. In the first, dealers act as market makers by maintaining bid and offer quotes. Dealers communicate these quotes, and the negotiation of execution prices, over the telephone and sometimes with the aid of an electronic bulletin board. This is known as bilateral trading because only the two ends of the phone observe prices at any one time.
The second type of OTC market, an electronic brokering market, is essentially the same as the electronic trading platforms used by exchanges. They are considered OTC because the contracts are less standardized, and the EBM does not necessarily clear the derivatives transactions.
The third OTC market type, exemplified by Enron Online, is a combination of the first two in which a dealer sets up its own proprietary electronic trading platform. In this arrangement, bids and offers are posted exclusively by the dealer so that other market participants observe only the dealer’s quotes but not one another’s. In this electronic trading, the dealer is the counterparty to every trade, so that the dealer holds half of the credit risk in the market.
The second question is why would the other side agree to such transaction? That party either thinks the peso will weaken by even more over the next six months (that is, he is willing to pay off the 50,000 pesos since he expects to make much more once the contract expires) or because his revenue stream is in pesos but he has a dollar-denominated loan (that is, he is willing to pay a 50,000-peso “insurance” to protect against a sharp weakening in the peso and a much higher debt service payment).
An option contract gives to its holder the right to buy (or sell) the underlying item at a specific price at a specific time period in the future. There are two basic kinds of options. Buying a call option provides an investor the right to buy an asset while a put option gives the investor the right to sell the asset. For instance, a call option will give the investor the right to buy, say, crude oil at $28 a barrel over a three-month period. If the market price rises above the strike price of $28 before the option expires (that is, before the three months are over), then the investor can exercise the option and capture a profit equal to the market price less $28. Say for example the price of oil rises to $30. The investor will exercise the option by buying oil at $28 and then sells it in the open market at $30, thus pocketing the $2 profit. If, on the other hand, the price never rises above $28 or even falls below that level, then the option expires worthless or “out of the money” and the investor loses the money (known as the option premium) he paid for the option.
A put option is similar. Take the example of coffee. A put option would provide an investor the right to sell coffee at a strike or exercise price of $0.65 per pound; if the price were to fall to say $0.60, then the investor would be able to exercise the put option (that is, sell the coffee at $0.65 while buying from the open market at $0.60) and gain $0.05 for every pound of coffee covered by the options contract.2
Just like in any financial transaction, there are two sides to every contract. Whereas the buyer of a call option has the right to buy an asset to profit from a favorable price movement, the seller of the same option (known as the “short options” position) has the obligation to sell the same asset if the option is exercised. The option writer is essentially selling price protection to the buyer, who pays a “premium” for the insurance.
Employee stock options are currently a financial-policy issue. They are nothing more than call options that are paid or granted by the corporation to an employee. The corporation is the option writer in that, if the employee decides to buy the company stock at a certain price, the corporation has the obligation to sell it at that price.
Credit derivatives permit the transfer of credit exposure between parties. Each contract has two parties: the credit-protection buyer and the credit-protection seller. The buyer of protection is typically an owner of an asset that is vulnerable to a credit event (for example, bankruptcy). To protect himself against this possibility, the asset holder buys “protection” by entering a credit-default swap so that if the bankruptcy actually does occur, the derivatives counterparty compensates him for the asset’s loss of value. The seller of the protection essentially believes that the risk of a bankruptcy is low and that the payment he receives from selling the protection will more than compensate him for the risk he takes on.
Structured securities are a rapidly growing segment of the derivatives markets. They typically combine features of conventional securities and with those of derivatives. The term “structured” refers to attached or embedded derivatives. Familiar examples of structured securities include callable bonds (that is, bonds that the borrower has the right to redeem even before they mature) and convertible bonds (that is, bonds that are convertible into a company’s stock).
In the 1990s, “putable” bonds and loans, used to structure lending to developing countries, gained notoriety for their role in financial crises. The attached put options allowed the lender to demand repayment of the debt in the event of a financial crisis or other “credit event.” Most of these structures were entered into during times of stability when the chances of a crisis seemed remote. Borrowers agreed to them since they reduced the cost of debt (that is, lowered interest cost). However, when the crises hit, borrowers ended up facing massive and unexpected debt obligations precisely at a time when they were least able to afford those obligations. The IMF estimated in 1999 that there were $32 billion in debts putable through the end of 2000 for all emerging countries. Of the total, $23 billion was to East Asian borrowers, and $8 billion was to Brazil.3
PUBLIC CONCERNS
As an indication of the dangers derivatives pose, it is worthwhile to recall a shortened list of recent disasters. Long-Term Capital Management froze U.S. credit markets when it collapsed with $1.4 trillion in derivatives on its books. Sumitomo Bank in Japan used derivatives to manipulate global copper markets from 1995 to 1996. Barings, one of the oldest banks in Europe, was quickly brought to bankruptcy by over a billion dollars in losses from derivatives trading. Both the Mexican financial crisis in 1994 and the East Asian financial crisis of 1997 were exacerbated by the use of derivatives to take large speculative positions on fixed exchange rates. Most recently, derivatives played many roles in the collapse of Enron—the largest bankruptcy in U.S. history at that time.
In addition to disasters, there are public concerns with credit risk, the lack of transparency, and the abuse of derivatives for fraud and manipulation. Derivatives trading, especially in the over-the-counter market, results in many payment obligations between firms. A large price movement can generate large payment requirements that increase the likelihood of default. A default at one firm affects the ability of other firms to meet their obligations and possibly leads to systemic failures. Warren Buffett described this as “daisy chain risk.”
Derivatives markets and corporations’ derivatives positions are also less transparent than other financial assets and financial transactions. It is hard for all but derivatives dealers to know the price and trading volumes in OTC derivatives markets. Investors cannot observe a firm’s derivatives position and thus cannot make an informed judgment as to whether it is hedged or speculating or whether it is speculating long or short.
ABUSE OF DERIVATIVES
The same powerful tools that are used for risk management can be used for unproductive, if not destructive, purposes. The flexibility and unregulated nature of OTC derivatives makes them highly effective instruments to abuse for the purpose of avoiding taxation, dodging or out-flanking prudential market regulations, and for distorting or manipulating accounting rules and reporting requirements. They can also be employed in the commission of criminal acts of fraud and market manipulation.
Derivatives can also be used to avoid, or evade taxation by restructuring the flow of payments so that earnings are reported in one period instead of another or in one country instead of another. They can also be used to transform interest and dividend income into capital gains, or vice versa.
Derivatives played an important role in the financial crises of Mexico and East Asia. Regulators in both cases set limits on banks’ exposure to foreign-exchange risk; however, the restrictions applied only to foreign exchange positions held “on” the balance sheet. Banks (ab)used derivatives to outflank these restrictions by moving positions into an “off-balance sheet” status.
The collapse of Enron and the revelation of other corporate scandals in the U.S. have disclosed other abusive practices. Derivatives were used to hide debt that should have been reported in regular corporate reports, to fabricate income on the same corporate reports, and to dodge taxes to the government. A series of derivatives between the same counterparties can be abused to create a loan from one firm to another that is not reported as debt but rather as income in one period when the “loan” is made and then a loss in a later period when the “loan” is repaid.
Derivatives can be an effective weapon for market manipulation. Information-based manipulation involves insider trading or making false reports on the market. Action-based manipulation involves the deliberate taking of some actions that changes the actual or perceived value of a commodity or asset. For example, investors may take a position on the stock and then pursue legislation or regulatory changes that might be passed to change the value of the assets.
Trade-based manipulation is the classic case of using one market to capture the gains from creating a price distortion in another interrelated market. How does this work? A manipulator acquires a large position in the derivatives market for crude oil through a long position in forward or swap contracts for future delivery or future payments based on the future price of oil. The manipulator next goes into the spot or cash market and buys enough crude oil to push up the price. This raises the value of the long derivatives positions, and these can be sold at a profit without driving the oil price back down. Then if the manipulator can sell off its inventory of oil without incurring substantial losses, the manipulation will be profitable.
Some recent cases of market manipulation using derivatives:
Avista Energy, electricity, 1998. Enron, electricity, 1998.
Enron, et al., electricity and gas, 2000 and 2001. Arcadia, crude oil, 2001.
Fenchurch, U.S. Treasury securities, 1993.
Ferruzzi, soybeans, 1989.
Sumitomo, copper, 1995 through 1996.
POLICY SOLUTIONS
The three pillars of prudential regulation of financial markets should apply to the derivatives market, especially OTC derivatives markets, as well. These are: (1) registration and reporting requirements; (2) capital and collateral requirements; and (3) orderly market rules.
Registration requirements help prevent fraud by requiring key individuals to pass competency exams (for example, as stock brokers and insurance agents are currently required to do) and background checks for criminal records for fraud. If someone is convicted of securities fraud, he or she is barred for life from securities brokering, but under current law he or she can go to work for an unregistered derivatives dealer the next day.
Reporting requirements make markets more transparent by giving all market participants equal access to prices and other key information. It also gives to regulators the ability to observe markets in order to detect problems before they become a crisis.
All derivatives transactions should be adequately collateralized. Enron’s failure exposed several bad industry practices. The current practice is to “super-margin” a firm if its credit rating drops (that is, if rating agencies downgrade the firm). This immediately raises the amount of collateral the firm must post against its derivatives positions just at the time the firm is experiencing problems with inadequate capital. This amounts to a crisis accelerator. Adequate collateral requirements should be set in the beginning, not after the trouble has started.
Derivatives dealers should have adequate capital. Dealers who are banks or securities broker-dealers already face capital requirements—although they do as banks and broker-dealers and not as derivatives dealers per se. However, entities such as Enron do not face any capital requirements. Capital is important because it reduces the incentive for risk taking and serves as a buffer to dampen losses at the dealer from becoming defaults and translating into losses for other trading partners.
Orderly market rules are the third pillar of market safety and soundness. One basic rule is to require OTC derivatives dealers to act as market makers. Dealers are in a privileged position in the market, and so they should bear the responsibility—like security dealers—of ensuring market liquidity by maintaining bid-ask prices continuously through trading hours. Another basic rule, borrowing from futures exchanges, is to set position limits and price-movement limits. Lastly, OTC markets should be encouraged to establish clearinghouses in order to increase the efficiency of the clearing and settlements process. The latter, in addition to improving trading liquidity, reduces the threat of system failures that can quickly reverberate across the financial system.
CONCLUSION
The enormous derivatives markets are both useful and dangerous. Current methods of regulating these markets are not adequate to assure that the markets are safe and sound and that disruptions from these markets do not spill over into the broader economy.
TIPS FOR REPORTERS
There are not a lot of data on derivatives. Futures and options exchanges provide the most information (see links, below), but there is far less information on OTC derivatives. Official sources of data on OTC derivatives include the BIS, the U.S. Treasury, the Bank of England, and the U.S. Federal Reserve Board for interest rates on swaps. Some additional information is included as footnotes to 10q and 10k SEC filings, however, this is most likely to be distilled down through aggregation.
It is important to ask market participants how they manage collateral (what assets are accepted as collateral, whether there is a threshold before collateral is required, and how quickly must changes to collateral be met). A critical feature of collateral management is whether counterparties must post substantially more collateral if their credit rating drops—this can accelerate a crisis as firms get into trouble for one reason and then are pushed into further trouble by their collateral obligations.
A good line of follow-up questioning concerns how the firm is assessing the credit risk of their trading counterparties. They should be making evaluations of the ability of their counterparties to perform on derivatives contracts, and they will look at official credit ratings as well as their own credit analyses in order to make these assessments. The problem is that the use of credit derivatives has made it much more difficult to judge the credit exposure of other participants in the market.
Another important question is whether a firm is a market maker (dealer) or an end user. Dealers engage in a large volume of trading by going long and short against their customers and other dealers. As a result, the amount of their outstanding contracts is much larger than their net position on the market. Their role is critical because if they cease maintaining bid and offer prices throughout the trading day, the market loses liquidity and can become illiquid.
If the firm is not a dealer but an “end user,” then it is important to ask how the firm observes prices and makes trades with the dealers in the market—this is likely to be over the telephone and sometimes enhanced with an electronic bulletin board, but it increasingly involves an electronic trading platform where traders observe market prices and directly execute trades.
LINKS FOR MORE INFORMATION
7. CFTC: Commodity Futures Trading Commission. www.cftc.gov.
13. Euronext and LIFFE: London International Financial Futures and Options Exchange. http://www.liffe.com.
NOTES
1. The design of the swap is thought to have originated from the practice of hedging cross-currency interest rates by making back-to-back loans. See Charles W. Smithson, Clifford W. Smith Jr., and D. Sykes Wilford, Managing Financial Risk: A Guide to Derivative Products, Financial Engineering, and Value Maximization (New York: Irwin, 1995).
2. The New York Board of Trade futures and options contracts are for 37,500 pounds.
3. IMF, Involving the Private Sector in Forestalling and Resolving Financial Crises (Washington, D.C.: Policy Development and Review Department, 1999).