Defined, Described and Distinguished
By Leo Melamed
March 13, 2008
in the financial world is talking about derivatives. Precious
few understand the subject. In truth, before 1990, one would
be hard-pressed to find the word “derivatives” in
financial textbooks, nor would you have encountered the acronyms
like SWAPS, CDOs, or SIVS and so on. In 2006, you would have
to scour the pages of the Wall Street Journal to find
even one mention of SIV. Today, it is literally impossible
to open the pages of national or international financial
publications without encountering those acronyms again and
reason is quite simple. The financial instruments we are
talking about are a modern invention, a consequence of computer
technology. As we all know computer technology changed the
course of civilization. With computer technology, financial
engineers learned to divide risks inherent in stocks, bonds,
foreign exchange, and commodities into their basic components.
In other words, to disaggregate, repackage, and redistribute
risks and their corresponding rewards, exchanging one set
of risks and rewards for another that responded better to
an investor’s preferences. We entered the era of particle
finance, which impacted every aspect of markets and investments.
simplest definition of derivatives is that they are instruments
of finance—the value of which is determined by reference
to one or more underlying assets or indices. They are used
as a management tool to enhance investment returns or protect
against inherent business exposures in foreign exchange rates,
interest rates, equity values, and commodity prices.
China Banking Regulatory Commission (CBRC), in promulgating “Interim
Rules on Derivative Business of Financial Institutions,”
offered a similar definition: a type of financial contract the
value of which is determined by reference to one or more underlying
assets or indices, including forward, swap, option and other
transactions with derivatives features.
are applied primarily in over-the-counter (OTC) form and
traded privately among banks and their large corporate and
institutional customers. Futures contracts are primarily
traded on regulated exchanges. Combined, these two sectors
represent a multi-trillion-dollar market.
the financial markets, both OTC derivatives and exchange-traded
futures, provide risk management capabilities on a vast array
of products, from finance to energy, from securities to the
environment, from banking to agriculture. These instruments
are used by domestic and international banks, public and
private pension funds, investment companies, mutual funds,
hedge funds, energy providers, asset and liability managers,
mortgage companies, swap dealers, and insurance companies.
derivatives markets have been enormously successful and have
grown rapidly since the BIS began monitoring them in 1995.
Notional amounts outstanding of OTC derivatives of all types
increased more than tenfold between 1995 and 2007, a growth
rate of over 20 percent per year.
global exchange-traded futures grew from $38.6 trillion in
1994 to $400 trillion in 2007. Their growth at the CME, for
instance, the world’s largest futures exchange, has
been dramatic. Annual CME average daily volume (ADV) has
risen from 917,000 in 2000 to 11 million in 2007.
prudent risk controls in place, for the vast majority of
financial managers, OTC derivatives have worked exceptionally
well. Used properly, they allowed market risks to be adjusted
quickly, more precisely, and at lower cost than is possible
with any other financial procedure. A process that has improved
national productivity, growth, and standards of living. However,
these complex and sophisticated financial tools require expert
comprehension. Used improperly, they can create unacceptable
striking difference between the OTC derivatives market and
futures exchanges is that futures traded on exchanges are
generally standardized products in currencies, interest rates,
and equities. They provide risk management to an entire asset
class—call it the big. On the other hand, the OTC market
has created an array of derivatives products that are narrow-based,
nonstandard, and often tailored to the needs of a specific
customer or group of customers—call it the little.
me to briefly describe two of the most utilized OTC derivatives,
the ones you have been reading about recently: the collateralized
debt obligation, CDO, and the structured investment vehicle,
their introduction in the late 1980s, CDOs became the fastest-growing
sector of the asset-backed synthetic securities market. It
begins when an investment bank creates a CDO and provides
it with an inventory of asset-backed securities. The collateral
assets are restricted to debt—for example, corporate
bonds, emerging market bonds, asset-backed securities, mortgage-backed
securities, REITs, bank debt, bank loans, and other credit
derivatives. Although CDOs vary in structure and underlying
collateral, the basic principle is the same.
CDO entity then slices the assets and liabilities into tranches
by reference to credit risk and income. Rating agencies rate
the tranches. The CDO now sells the tranches (cash flows
coupled with inherent risk) to investors based on their risk
objectives. The investors take a position not in the underlying
assets but in the CDO entity that defined the risk and reward
of the inventory. Consequently investors are dependent not
simply on the quality of the inventory but also on the quality
of the calculations made by the creators of the CDO model.
That is critical to understand: Values are not determined
by mark to market but by the calculations in the model. The
greater-risk pieces of a CDO pay greater returns to their
investors. The investment bank gets management fees for managing
SIV is an OTC structured investment vehicle. The concept,
initiated in 1988, was very novel. Similar to a CDO, it can
be likened to a virtual bank. A bank could create a fund
that would borrow money—short term—by issuing
commercial paper close to the interest rate of LIBOR. Then
it uses the money to lend—long term—by investing
in asset-backed securities and mortgage-backed securities
(mortgages, credit cards, student loans, and similar products).
Liabilities are again sliced into tranches by reference to
the credit risk, and then rating agencies would rate the
tranches. The tranches are sold to investors based on their
risk objectives. The difference between the earnings on the
bonds and the interest on the commercial paper represents
the profit for the investors of the SIV. Since the bank does
not take the credit risk, it can keep the SIV’s debt
off its balance sheet while receiving a management fee from
the SIV. The SIV industry grew to become a $400 billion industry.
purpose here today is to define, describe, and distinguish
derivatives and futures. It is decidedly not to assess U.S.
or global economic conditions. Still, it is difficult to
accomplish my assignment without at least a brief mention
of the fact that global economic conditions have deteriorated.
Not being an economist, it is not for me to point fingers.
Indeed, there is no single culprit; there is plenty of blame
to go around. But clearly the root cause can be found first
in the fact that during the past decade, the world became
awash with liquidity, resulting in a global economic bubble.
Easy credit created a pyramid of debt. Second, greed led
to a lack of financial discipline. Finally, these conditions
led to a breakdown of proper risk management controls.
suppose much of what went wrong lies in the propensity for
human nature to take a good thing too far. It is as true
in finance as it is in every form of human endeavor. Cheap
credit induced a housing boom, especially in the U.S. It
was grounded in the fallacious belief that housing values
will go up forever. Risk became excessively underpriced.
As home prices and mortgage lending boomed, bankers found
ever more clever ways to repackage trillions of dollars in
loans, selling them off in slivers to investors around the
world. In a rush for better returns, some banks abandoned
common sense. They disregarded proper risk controls. It was
a recipe for disaster. The OTC CDOs and SIVs had a role in
that result, becoming tools for this dangerous application.
Randal Forsyth, the financial writer for Barron’s, offered
the following analogy: He suggested that just as steroids,
a modern medical invention, helped the performance of baseball
players, SIVs, a modern financial invention, helped the performance
of banks. The use of SIVs was of course not illegal, but
the analogy is valid since their purpose was to keep the
given risk off the bank’s balance sheets. In doing
so the bank’s returns looked much better. Until, that
is, the market itself forced the truth to come out.
problems unfolded when subprime mortgage loans in the U.S.
began to have trouble meeting their mortgage obligations.
In the summer of 2007, weaknesses in the short-term debt
market soon sparked a broader credit crisis. The financial
world watched with increasing concern as the commercial paper
market—on which SIVs rely for much of their funding—began
showing severe strain. The difference between the yields
on Treasury bill—safe—investments and corporate
commercial paper grew sharply. Soon short-term rates skyrocketed
and short-term lenders disappeared. The emergency actions
by world central bankers did little to stop a contraction
of credit and cascading of defaults. The rest is history:
Stock markets throughout the world became pressured, consumer
confidence fell, market volatility increased, the U.S. housing
market fell into disarray, unemployment rose.
the depth of the problem has been recognized. Regulators
from France, Germany, Switzerland, the U.K., and the U.S.
issued a joint report, released a few days ago, on March
6, 2008, which stated the obvious: Major banks and securities
firms that have suffered huge credit losses failed to understand
the inherent risks of the securities they bought. Bank losses,
the report stated, were incurred by
“concentrated exposure to securitizations of U.S. subprime mortgage-related
credit.... In particular, some firms made a strategic decision to retain large
exposure to super-senior tranches of collateralized debt obligations that far
exceeded the firms’
understanding of the risks inherent in such instruments.”
and Futures Distinguished
have the problems in the credit markets seemingly not spilled
over into the futures exchanges? It is an important question
with some very sobering answers.
In stark contrast to the turmoil of recent events, the CME
clearinghouse has operated for more than 100 years without
failure. In 2007, the CME Clearing House cleared more than
2.8 billion contracts traded on the CME/CBOT, representing
more than a quadrillion dollars in notional value terms.
In December 2007, the BIS Quarterly Report explained
some of the dramatic differences between the OTC derivatives
and exchange traded futures:
OTC derivatives market greatly overshadows exchange-traded
futures instruments. One reason is that in futures, an
offsetting position eliminates the original contracts;
not so in the OTC market, where the original contract
remains in place increasing the total size of the market.
markets generally lack the regulatory control of federal
authorities to which futures and options exchanges are
markets do not have the protective components of the
futures exchanges, namely: daily mark-to-the-market value
adjustments, margin deposits, price and position limits,
and most notably the guaranty of a central clearing house.
OTC derivatives may take place on multilateral trading
platforms, clearing and settlement is by its very nature
bilateral—this means OTC derivatives are not assets
that can be traded freely.
with different counterparties are usually not fungible,
which makes it difficult for traders to close positions.
Contracts often have long maturities, and counterparty
risk is a much greater concern in OTC derivatives markets
than in securities markets.
OTC derivatives contracts may themselves be very complex,
involving payments that depend on prices of other assets.
differences are dramatic. While no system is perfect and
no one can foresee all eventualities, these structures and
procedures at regulated futures exchanges represent a time-tested
mechanism—the very essence of their default-free success.
On regulated exchanges, not only are disclosure and transparency
the hallmarks of their transaction and clearing mechanisms,
there can be no doubt about the integrity of their daily
settlement procedures. Even in the most distant Eurodollar
contract at the CME—priced 10 years into the future—there
exists a real price established every day in a notoriously
open forum—now primarily Globex. To be specific, the
exchange futures clearinghouse system of multilateral clearing
and settlement provides:
Counterparty Clearing (CCP), with a central guarantee
to every transaction— eliminating counterparty
of valuation with twice-daily (at the CME) mark-to-market
disciplines—eliminating accumulation of debt.
confirmation from a trusted counterparty directly to
the back office and the risk manager—risk management
systems know the trade the moment it is done. No confirmation
means no trade.
payment of settlement variation and margining—making
it difficult for traders to hide losses or disguise unusual
oversight and financial surveillance procedures—the
antithesis to the largely unregulated OTC market.
is not to say, that OTC derivatives are to be banned or feared.
That would be unthinkable. For the vast majority of financial
managers, whether OTC or exchange traded, these risk management
tools work exceptionally well. It is estimated that over 90%
of the world's 500 largest companies—domestic and international
banks, public and private pension funds, investment companies,
mutual funds, hedge funds, energy providers, asset and liability
managers, mortgage companies, swap dealers, and insurance companies—use
OTC derivatives to help manage their business exposure. Nor
could it be different in today’s complex and interdependent
financial world. Indeed, if OTC derivatives application were
suddenly not available in business today, they would have to
be invented. Without them, it would be like going back to the
Stone Age. Still, the lessons learned must be applied. It is
imperative that OTC derivatives have a measure of regulation,
transparency, and disclosure of attendant risks.
Buffett, the world’s most respected investor, offered
the best assessment of the cause of today’s economic
problems: He compared money managers who promised double-digit
returns to the queen in Alice in Wonderland who proclaimed: “Why,
sometimes I’ve believed as many as six impossible things
before breakfast.” Just like the queen, he explained, “Just
about all Americans came to believe that house prices would
forever rise.” That conviction made one’s income
and savings unimportant. Lenders offered a seemingly unending
funnel of money to borrowers “confident that house
appreciation would cure all problems.” Today, we are
experiencing the pain of that impossible belief.
University professor Robert J. Shiller summed it up this
way: “The failure to recognize the housing bubble is
the core reason for the collapsing house of cards we are
seeing in financial markets in the US and around the world.
If people do not see any risk and only the prospect of outsized
investment returns, they will pursue those returns with disregard
for the risk.”
conclusion, I want to leave you with this thought:
instruments on regulated futures markets must be distinguished
from OTC derivatives. However, neither OTC derivatives nor
the markets themselves are to be blamed for the problems
the world faces today. The markets as well as derivatives
are tools—mechanisms that perform an important financial
function. The tools are innocent. They are applied by human
beings. Don’t blame the tools for the actions of fools.
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