Seven Concepts in Derivatives

The implosion of the markets in some complex derivatives in 2007-9 drew attention to this obscure corner of the financial realm. Derivatives are nothing new. They consist of the transfer of risk to third parties and the creation of a strong correlation or linkage between the prices of one or more underlying assets and the derivative contract or instrument itself. Thus, whenever guarantors sign on a loan or credit agreement, they, in effect, are creating a derivative contract. Similarly, insurance policies can be construed as derivatives as well as options, futures, and forward contracts.

There are two types of risk: specific to the firm or sector and systemic, usually the outcome of an external shock to the entire economy. Derivatives aim to mitigate risks, but what they actually do is concentrate them in the hands of a few major players. Risk markets encourage the transmission of financial contagion across borders and continents, exactly as do international trade and foreign investment (both direct and portfolio, or “hot money”). Indeed, liquidity: the uninterrupted availability of buyers and sellers in relevant marketplaces factors in the valuation of derivatives. In a way liquidity is another name for the solvency of markets.

The value of derivatives reflects mainly the specific risk with a touch of systemic risk added (measured via value-at-risk, or VAR models). It takes into account the solvency of issuers and traders of both the derivatives and of the the underlying securities or assets (known as “counterparty risk”). The simplest measure of solvency is the capital to debt ratio (“capital adequacy” and debt service measures). Earnings are also important: both historical and projected. High or rising earnings guarantee the wherewithal to pay at a future date. Debt to capital (or to earnings, or to net income, or to assets) ratios are basic gauges of leverage or gearing. A high leverage translates to an increased risk of default on financial obligations, such as the ones represented by derivative contracts. Worse

Still, it is not easy to evaluate a firm (especially in the financial services sector). There is no agreement on how to put a number to intangibles such as brand names, networks of clients and suppliers (loyalty), and intellectual property and, on the other side of the ledger, how to estimate contingent and off-balance-sheet liabilities (such as derivatives). Whether one is an issuer or a buyer, accounting standards (such as the IAS or FASB) are fuzzy on how to incorporate derivatives in financial statements. Primitive, automatic, supposedly pre-emptive mechanisms for the management of the risk of default, such as margin calls (a requirement to add fresh capital as losses mount on a position) often run into difficulties as gearing skyrockets and with it a commensurate counterparty risk. Put simply: margin calls are useless post-facto, when the issuer of a derivative, or its buyer (speculator or hedger) have gone insolvent owing to a high leverage or to losses incurred elsewhere.

There is also the question of recourse, or who owns what and who owes what to whom and when. Securitization has led to the emergence of spliced, diced, and sliced derivative instruments whose origin is obscured in pools of primary and secondary and even tertiary securities. Often, the same asset gives rise to conflicting claims by the holders of a bewildering zoo of derivative contracts which were supposed to function as clear conduits, but whose passthrough mechanisms were far from unambiguous or unequivocal. This intentional fuzziness prevented the formation of clearing and settlement houses or systems, exchanges, or even registries, akin to the ones used in the stock markets. The lack of transparency in the derivatives markets was deliberate, aimed at fostering insider advantages in a “shadow system” with “dark pools”.

Conflicts of interest were thus swept under a carpet of complexity and obscurity. Financial firms traded nostro (for their own accounts) and against their clients. Preferential customers received benefits that were denied their less privileged brethren. Accounting rules were abused to engender the appearance of health where rot and decay have long set in (for instance, high default swap rates – indicating imminent collapse – allowed firms to book lower loan loss provisions and show higher profitability!) Agents (executives and traders) ran amok, blindly robbing shareholders in a perfect illustration of the Agency Problem (or agent-principal conundrum).

A pervasive lack of disclosure allowed a culture of insider trading to flourish. Auditors were compromised by huge fees. They could not afford to lose the bigger clients, which often constituted the bulk of their practice. Rating agencies – whose fees were doled out by the very firms and issuers they were supposed to evaluate professionally and without prejudice – proved to be venal and their work disastrously misleading. The name of the game was asymmetric information: a rapacious elite amplified the inefficiencies of the market to indulge in arbitrage and rake in baroque personal profits.

Regulatory and supervision authorities were helpless to prevent the slide along the slippery slope into mayhem: they suffer from inefficiencies, the inevitable outcomes of overlapping jurisdictions; inherent conflicts of remit (for instance, central banks clashed with bank supervisors over whether asset bubbles should be deflated and the stability of the financial system thus threatened); a revolving door syndrome (regulators became banking and Wall Street executives and vice versa); deficient training; and a lack of supra-national coordination and exchange of information.

None of these pernicious facts was a secret. Everyone treated the derivatives markets as glorified gambling dens. Losses were expected and a Ponzi scheme fatalism prevailed long before the cash dried out in 2007. The lack of trust that manifested later and the resultant lack of liquidity were no surprise (though the financial community feigned a collective shock).