DEFENSE OF DERIVATIVES
March 7, 1994
the last half of this century, science has moved from the big
to the little, from the vast to the infinitesimal. From general
relativity to quantum physics, from individual cells to genes.
The advances in financial markets have been strikingly similar,
but much faster. We are now in the Age of Derivatives, financial
equivalents of particle physics and molecular biology. We have
moved from long-term hedging to on-line risk management; from
macro to micro.
new era dawned in the early ‘Seventies, when the Chicago Mercantile
Exchange launched the International Monetary Market to develop
trading in financial futures. Thereafter, evolutionary forces
in finance, technology, global markets and world economies transformed
these simple tools into complex derivatives that can deal with
the fundamental components of financial risk.
secure their values from other assets, such as stocks, bonds,
currencies, or commodities. Simple futures contracts in foreign
exchange, Eurodollars and bonds have become swaps and swaptions,
strips and straps, collars and floors. Investment evolution is
the offspring of necessity.
live in a highly hazardous economic environment, in which competition
is global, volatility is constant and opportunities rapidly appear
and disappear. Derivatives reduce risk and boost profits. They
enhance the efficiency of businesses, benefit bank depositors
and borrowers, improve portfolio managers’ performance and help
farmers, mortgage lenders and commercial users of energy. Derivatives
have fostered rapid growth in international trade and capital
flows, allowing excess savings in mature industrialized countries,
for example, to be funneled into higher-yielding opportunities
in developing nations.
should be noted that there are two types of derivatives: privately
traded over-the-counter instruments that circulate among banks
and their large corporate and institutional customers, and exchange-traded
ones — financial and commodity futures and options. Combined,
these two sectors add up to a multitrillion-dollar market.
the OTC derivatives market is the larger, it lacks the exchanges’
protective components, such as daily mark-to-market value adjustments,
required margin deposits, price and position limits and, most
notably, the guarantee of a central clearinghouse. OTC products
also lack strict regulatory oversight.
Warning From Kaufman
there are both bulls and bears on derivatives. Many argue that
derivatives endanger the world’s financial fabric. Economist
Henry Kaufman, while fully acknowledging their benefits, has
warned: "The high market volatility of our new financial world
and the potential for even higher volatility given the broad
range of instruments available to participants contain the seeds
of potentially adverse consequences for investment, for credit
creation, and ultimately for monetary policy."1
whatever the exposure, it is off-balance sheet, potentially volatile
and difficult to assess. And the sums involved are enormous.
Regulations for strict accounting procedures and reserve requirements
of year-end 1991, a Commodities Futures Trading Commissions study
reports, there were 20 U.S. swap dealers with notional principal
exceeding $10 billion. And the Securities and Exchange Commission
indicates that aggregate notional principal held by major U.S.
broker-dealer affiliates on interest rate and, currency swaps
and foreign-exchange forward contracts roughly equaled the aggregate
value of these dealers' futures positions.
few large end users account for much of total industry activity.
According to Barron's, the inner circle includes Bankers
Trust, Citicorp, J.P. Morgan, Chemical Bank, Chase Manhattan,
Swiss Bank Corp., Deutsche Bank, Societe Generale, Merrill Lynch,
Goldman Sachs, and Salomon Brothers.2 From
there, the exposure circles widen dramatically.
are few, if any, known loan-loss reserves within this off-balance
sheet market. Consequently, who is on the other side of the risk
is a very important question. Nevertheless, the CFTC study concluded
that "no fundamental changes in regulatory structure appear
to be needed at this time." Similarly, a recent analysis by the
Group of Thirty, a private-sector task force headed by former
Fed Chairman Paul Volcker, concluded that derivatives don’t add
to the risk that already exists in today’s financial environment.
isn’t to say, however, that the global financial system isn’t
vulnerable to a major shock from wars, political upheaval, economic
dislocations, natural disasters, etc. Quite the contrary. At
today’s market levels, such vulnerabilities are magnified.
it’s important to realize that the current world bull market
in financial assets is highly dependent on liquidity. Should
liquidity diminish, these assets would be significantly exposed.
And derivatives add liquidity.
has noted that derivatives evolved following the dramatic rise
in "floating rate financing opportunities; massive securitization
of mortgages and other financial products; sweeping internationalization
of trading of currencies, bonds and equities; a striking shift
toward institutionalization of portfolio investment; and a worldwide
explosion of budgetary deficits, and the associated mushrooming
of so-called risk-free government bonds...."3
trends aren’t about to change.
we’re poised for another quantum technological leap, via "artificial
intelligence," a phrase that embraces such trading innovations
as neural networks, fractals and chaos theory. Many major American
brokerage firms already have quietly spent hundreds of millions,
perhaps billions, to develop this technology.
fears voiced about the risks in derivatives echo those generated
about genetic engineering. And just as Congress has found it
impossible to fully direct the development of genetic research,
it will find it is impossible to stop financial engineering.
In a global market, the ingenuity of physicists, biologists and
financial market participants will continue unabated. And so
will the Age of Derivatives.
Kaufman, "Financial Derivatives in a Rapidly Changing Financial
World," London, England, 14 October 1993.
R. Laing, "The Next Meltdown," Barron's, 7 June 1993.
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