The Threat of Derivatives to the Global Financial System

By Adil Rasheed

13 Jan 2010

In the last two decades, a new and innovative form of trading in complex financial instruments called ‘derivatives’ has caught the fancy of investors around the world. Considered by many economists as extraordinarily useful in providing excess liquidity and stability to the markets, these complex products of financial speculation have ballooned into a $700 trillion global market, which is at least ten times the size of the global GDP.

However, a growing number of economists and investors have started calling the trade in derivatives as the principal cause of the current global financial meltdown, and regard the US subprime mortgage crisis as merely the trigger for dangerous financial instruments—like Collaterized Debt Obligations (CDO) and Credit Default Swaps (CDS)—to unleash an incipient disaster. They aver that the unraveling of banks and financial institutions like Lehman Brothers, American International Group (AIG) and Citigroup that led to the current global financial crisis was a result of the enormous ‘toxic assets’ produced by the derivatives trade.

Even the supporters of these innovative financial instruments now concede that derivatives could work as a double-edged sword, which if unregulated and misused could cause major systemic flaws. Thus, many prominent global economists, investors and politicians have started expressing the fear that unregulated derivatives trade could still become the bane of the global financial system. Nobel economics laureates Joseph Stiglitz, George Akerlof and Myrol Scholes, and renowned investors like George Soros and Marc Faber have called for outlawing at least some of the most complex derivatives like Credit Default Swaps (CDS). Legendary entrepreneur and investor Warren Buffett has gone so far as to call derivatives “financial weapons of mass destruction.”

Despite the enormity of the problem, few understand the complexities involving derivatives or are able to wade through the soup of their abbreviated names like CDOs, CDSs etc. In plain terms, derivatives are financial instruments that do not hold any intrinsic worth but derive their value from an underlying asset, index, event, value or condition. These products are used to speculate or hedge individuals or businesses from perceived risks. Thus, instead of trading or exchanging the underlying asset itself, derivative traders enter into an agreement to exchange cash or other assets over time based on an underlying asset. In other words, derivatives are not assets in themselves, but financial deals made about assets, many of which are simply bets.

Derivatives are generally categorized by the relationship between the underlying and the derivative (for example forward, exchange or swap), the type of underlying asset like currencies, interest rates, shares, debt, property etc. and the market in which they trade (e.g. exchange-traded or over-the-counter derivatives).

These innovative products are so new and complex that their benefits and dangers have not yet been fully tested, explored or comprehended. Often, it takes advanced mathematics to clearly understand how they work. This complexity creates an aura of mystery about derivatives, and there is always an inherent danger of miscalculation. Any undetected error could potentially cause systemic risks. This flies in the face of the maxim circulated in the media today that one should not invest in what one does not understand.

There are also many other risks and dangers associated with derivatives trade. First, derivatives do not require the actual ownership of the underlying asset, and the level of bets often outstrips the level of underlying assets. Thus, even a small move in the value of the underlying asset causes a huge difference in the value of the financial instrument and causes huge anomalies for various financial institutions.

Second, derivatives are usually highly leveraged, as hedge funds and banks which trade in them make extensive use of borrowed money to increase their returns. Thus, investors who make huge amounts of money in the event of an upturn also sustain massive losses even in a marginal downtick, particularly on borrowed money which has a cumulative impact on the financial system in a variety of ways.

There have been many instances of massive losses in derivative markets, such as the crisis that hit AIG, which was overcome only after $85 billion of bailout money was provided by the US government, the loss of $7.2 billion by Societe Generale in January 2008 because of the futures contracts related crises, the $6.4 billion loss in the failed fund Amarnath Advisors in September 2006, the loss of $4.6 billion in the failed fund Long-Term Capital Management in 1998 etc.

Again, majority of derivatives trade is unregulated and takes place between two parties, without going through an exchange or other intermediary. These Over-the Counter (OTC) derivatives, which have an estimated outstanding notional amount of $684 trillion (according to Bank of International Settlements figure of June 2008), often involve high-risk products like swaps, forward rate agreements and exotic options and are free of any regulation as regards disclosure of information between parties. Estimates of OTC amounts of derivatives are difficult because these trades often occur in private. Moreover, the OTC market is made up of big banks and hedge funds, which are too vulnerable and too big to fail for the health of the financial system.

Many economists of the Austrian school deride the derivative market as a “casino” and call it a financial innovation of the Greenspan era that helped “hide the bankruptcy of the financial system following the 1987 stock market crash.” It is alleged that this virtual market was created to allow big banks and speculators to bet on movements of currencies, bonds, stocks and indices associated with them and thereby revive the economy. However, following the bust in the derivatives bubble in 2008, central banks have been allegedly printing money to pay for the “fictitious values and profits” of these derivatives, which in turn is building a hyper-inflationary bomb that has the potential of destabilizing the global financial system once more.

The above claims appear exaggerated, still the US Congress and the Obama administration has started introducing legislation and measures to regulate the unfettered excesses of derivatives trade. However, many in the US Congress are skeptical about the effectiveness of proposed regulations. The chairman of the newly formed Economic Recovery Advisory Board under President Obama and former Chairman of the US Federal Reserve, Paul Volcker is himself a major critic of these products of financial engineering. In a recent interview he said: “I hear about these wonderful innovations in the financial markets, and they sure as hell need a lot of innovation. I can tell you of two—credit-default swaps and collateralized debt obligations—which took us right to the brink of disaster.” With a tinge of sarcasm he later added that for him the best financial innovation in recent decades has been the ATM machine.

http://www.ecssr.ac.ae/ECSSR/print/ft.jsp?lang=en&ftId=/FeatureTopic/ECSSR/FeatureTopic_1205.xml