Derivatives

Randall Dodd

Introduction

Derivatives play an important and useful role in the economy, but – as the grave financial crisis of 2008 has amply demonstrated – they also pose several and severe dangers to the stability of financial markets and the overall economy.

Derivatives are often employed for the useful purpose of hedging and risk management, and this role becomes more important as financial markets grow more volatile. Derivatives markets also serve to determine the prices of many assets and commodities and the economic value of non-market 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 that 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 very volatile) price at which they purchase gas, oil and other source fuels as well as the (increasingly deregulated and, as such, variable) price at which they sell electrical power. International businesses hedge their (volatile) 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 4th century B.C. (Politics, chapter 9). Derivatives trading on an exchange can be traced back to 12th century Venice. In the early 17th century, futures and options were traded on stocks and commodities such as tulips in Amsterdam. The Japanese traded futures-like contracts on warehouse receipts for rice in the 18th century. In the U.S., 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 2008 by the Bank of International Settlements puts the amount of outstanding over-the-counter derivatives contracts in excess of $680 trillion. By comparison, the IMF’s figure for worldwide output, or GDP, is $65 trillion.

What Are Derivatives?

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 of 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. It 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 (party B to lend) $1 million for three months at a 2.85% 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 greater market liquidity. The public trading of futures in a transparent environment means that everyone can observe the market price throughout the trading day. How can this be? How can you substitute a futures contract in soybeans for one in yen?

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. 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. When the payments are to be made in the same currency, then only the net amount of the payments are made.

A “vanilla” interest rate swap is 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. A foreign exchange swap is comprised of 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. An equity swap has one series of payments based on a long (or short) position in a stock or stock index, and the other series of payments fixed or floating according to an interest rate or a different equity position.

Consider an example of a U.S. dollar for Mexican peso foreign exchange swap. 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 (i.e. buying pesos) but at an exchange rate of $0.0950 (thus receiving 1,050,000 pesos). In this trade, the investor made a 50,000 pesos profit because the value of the dollar rose against the peso.

An option contract gives its holder the “option” (or the right) to buy (or sell) the underlying item at a specific price at a specific time period in the future. There are two 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 $50 a barrel over a 3 months period. If the price rise above the strike price of $50 before the option expires (i.e., before the 3 months are over), then the investor can exercise the option and capture a profit equal to the market price less $50. Say for example the price of oil rises to $60. The investor will exercise the option by buying oil at US$50 and then sells it in the open market at $60 thus pocketing the $10 profit. If, on the other hand, the price never rises above $50 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 (i.e., sell the coffee at $0.65 while buying from the open market at US$0.6) and gain $0.05 for every pound of coffee covered by the options contract.

Just like any financial transaction, there are two sides to every contract. For example, 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, which were once very much in the news, 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 employer 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 (e.g., bankruptcy). To protect himself against this possibility, the asset holder buys an insurance policy (“protection”) so that if the bankruptcy actually does occur, the insurance provider compensates him for the asset’s loss of value. These derivatives can take the form of options, swaps or structured securities. It was this type of derivative that played a crucial role in the so-called “sub-prime” financial crisis in which home loans (or mortgages) were “bundled” into such structured securities and sold on to investors. These in turn were “insured” through credit swaps involving, among others, the insurance giant AIG, which had to be rescued by the Federal Reserve when the original loans went bad, creating “toxic assets”.

Structured securities are a rapidly growing segment of the derivatives markets. They typically combine features of both conventional securities and derivatives. The term “structured” refers to attached or embedded derivative or derivatives. Familiar examples of structured securities include callable and convertible bonds and convertible preferred 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 (i.e., lowered interest cost). However, when the crises hit, borrowers ended up facing massive and unexpected debt obligations precisely at a time when they could afford those obligations the least.

How derivatives markets work

Derivatives are traded in two kinds of markets: in exchanges and in over-the-counter (OTC) 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 (EBM) 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, the EBM does not set the contract design and the EBM does not 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 dealers quotes but not each others’. 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.

Public Concerns

The financial crisis and economic downturn that in 2008 beset first the rich countries and then reverberated through the global economy started with a housing price bubble, but it was turbo-charged by the unregulated derivatives markets. Complex investment instruments that were not properly understood even by those who traded them unravelled and spread panic throughout the financial world. This in turn brought down banks and struck so much fear into the markets that lending almost dried up and stock markets plunged. Once admired captains of banking and official policy were forced to admit that they had over-estimated the self-regulatory capacity of the financial markets. Presidents and prime ministers met to discuss a new world financial order. Amid all this, derivatives became almost a household (swear) word.

It is also worthwhile recalling a shortened list of previous disasters involving derivatives. Long-Term Capital Management froze U.S. credit markets when it collapsed with $1.4 trillion in derivatives on their 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 such disasters and long before the “sub-prime crisis” there were public concerns with credit risk, the lack of transparency and their abuse for fraud and manipulation. Derivatives trading, especially in the OTC 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 leads to systemic failures, such as that which culminated in the bankruptcy of the venerable investment bank Lehman Brothers. Warren Buffett described this as "daisy chain risk" and called derivatives “financial weapons of mass destruction.”

Derivatives markets and corporations' derivatives positions are also less transparent than other financial markets 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. When things went wrong in 2008, this added to the panic and volatility that gripped the credit and other markets.

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 earning 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 out-flank these restrictions by moving positions into the "off-balance sheet" status.

The collapse of Enron and revelation of other corporate scandals in the U.S. disclosed other abusive practices. Derivatives were used to hide debt that should be reported in regular corporate reports, fabricate income on the same corporate reports and 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, in 1998.
  • Enron, electricity, 1998.
  • Enron, etal, electricity and gas, 2000 and 2001.
  • Arcadia, crude oil, in 2001.
  • Salomon Brothers, U.S. Treasury securities, 1991.
  • Individual traders, U.S. Treasury securities, 1992.
  • Fenchurch, U.S. Treasury securities, 1993.
  • Ferruzzi, soybeans, 1989.
  • Sumitomo, copper, 1995 through 1996.

Policy Solutions

The financial crisis of 2008 led to hearings on Capitol Hill and other legislatures around the world designed to find out what happened and how to ensure it does not do so again. There have been calls for tighter regulation of the financial markets and the world can expect a period of re-examination of many of the assumptions behind market policies. Whatever policy-makers decide, the three pillars of prudential regulation of financial markets should apply to derivatives markets, 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 (e.g. 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 they are barred for life from securities brokering, but they 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 (i.e., 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 many of the market participants during the build-up to the 2008 crisis, including the investment banks and hedge funds, as well as entities such as Enron were not subject to 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, again borrowing from securities exchanges, is to set position limits and price movement limits. Lastly, OTC markets should be encouraged to establish clearing-houses in order to increase the efficiency of the clearing and settlements process and to decrease the threat of systemic risk.

Conclusion

The enormous derivatives markets are both useful and, as we now know, dangerous. The method of regulating these markets was not adequate to assure that the markets were safe and sound and that disruptions from these markets did not spill over into the broader economy.

Tips for writing about derivatives

  • There is not a lot of data on derivatives. Futures and options exchanges provide the most information (see links), but there is far less on OTC derivatives. Official sources of data on OTC derivatives include the BIS, the U.S. Treasury, 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 made it much more difficult to judge the credit risk of other participants in the market, as the Lehman Brothers’ bankruptcy illustrated.
  • Another important question is whether a firm is a market maker (dealer) or end-user. Dealers engage in a large volume of trading by going long and short against their customers and other dealers. As a result, their amount of 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.

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Type Backgrounder
Program Journalism Backgrounders
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