I’m sure the majority of you have heard of the term “derivatives” by now. What’s my take on the media hype? Thought you’d never ask. Derivatives can be a valuable financial tool when used properly. Derivatives are an efficient way to manage systemic risk, or to make that leap of faith into outright speculation. A great deal of turmoil and economic havoc resulting from misuse of these tools has vilified them along the same parallels as junk bonds. I heard an interesting chap today on NPR who was adding his two cents to the discussion as I drove home. He made a couple of poignant observations. First of all he prefaced his remarks with the note that the people who operate in these industries (contract writers, counter parties, and underwriters) are all financial professionals. I believe he was merely pointing out that we were all adults and aware of the complex structure of these fairly exotic agreements. Getting back to our friend, he thought it highly unlikely that no one ever thought of an economic downturn. He couldn’t understand how well educated professionals could fail to perform due diligence through stochastic modeling. After all folks, you don’t take the swap and “hope”. When did finance become such a spectacle? Secondarily, he suggested more regulation to prevent over-leveraging, and tighter controls on the Chicago Mercantile and CBOE where these trade OTC. I believe he made some fine points. The bottom line; derivatives don’t harm economies, irresponsible people do. Here’s some fine reading from the counter-point.
Crisis expert says derivatives market still 'grave threat'
By Chris Oliver, MarketWatch
HONG KONG (MarketWatch)
Risks of a major accident from derivatives use remain -- or may even be on the rise -- amid a wave of re-leveraging, according to an expert of the causes of the global financial crisis.
Noted financial author Richard Duncan said banks and other financial institutions are beginning to pile back into the opaque financial instruments, as the total value of such contracts is "probably back" to $650 trillion.
"This is a grave threat not only to the financial sector but also the entire global economy," Duncan said in a telephone interview with MarketWatch from his home in Bangkok as he prepares for a U.S. tour of his 2009 book, The Corruption of Capitalism. See previous story on crisis experts' recent book.
Duncan, the former London-based head of global investment strategy for ABN Amro, says investment banking culture hasn't changed much in the wake of the crisis, as the lucrative compensation schemes that led to the excessive risk taking remain intact.
The over-the-counter derivates market contracted in the wake of the financial crisis to $547 trillion in December of 2008, but ballooned more than $50 trillion in the following six months. It could now be approaching its former high of $683 trillion in June 2008, according to Duncan, who cited data from the semi-annual figures published by the Bank for International Settlements.
Roughly speaking, a 1% default rate would amount loss ratio of $7 trillion, or about 50% of annual U.S. gross domestic product, while a 10% loss rate would exceed the value of all goods and service produced around the world in a year.
Duncan continues to advocate tougher oversight of the derivatives market, but acknowledges bringing them to heel will come with risks.
Among them, global commodity markets could decline sharply, particularly crude oil, where supply and demand dynamics don't support prices anywhere near the $80-per-barrel level, he says. Oil futures traded over $83 a barrel on Tuesday.
"There is a good chance that a lot of commodities, if not all commodity prices are being manipulated through derivatives," Duncan says.
Another worry is what may surface as the opaque market comes under greater regulatory scrutiny.
"There is a really good possibly that new derivatives have been created each year to manipulate the price of derivatives in prior years. And if they forced everyone to trade through exchanges ... it could suddenly expose trillion of dollars of losses throughout the financial sector," Duncan says.
Another concern is the fallout for bank's bottom lines. Duncan says bank profits swelled along with the explosive growth in the derivatives trading, to occupy a disproportional large share of total corporate profits. That will likely come to an end, he says, if regulations tighten meaningfully.
Chris Oliver is MarketWatch's Asia bureau chief, based in Hong Kong.
