DOWNSIZING OF RISK
in China Futures
25 April 1995
Procter & Gamble
posts losses of $157 million by virtue of derivatives positions.
Atlantic Richfield, the American energy giant, loses some $22
million in financial derivatives in an employee investment
fund it manages. Piper Jaffray loses $700 million in a U.S.
Government-bond fund. Metallgesellschaft, the German industrial
giant, comes close to receivership after losing nearly $2 billion
in derivatives. California's Orange County loses $1.5 billion
in an aggressive derivatives strategy. Nick Leeson piles up
$1.3 billion in losses on derivatives in Singapore and Osaka,
and in one blow, the huge trading losses wiped out Barings,
the blue-blood British investment bank's $900 million in capital
and prompted the Bank of England to put Barings into bankruptcy.
such as these and many more have recently shaken the financial
community—the reported losses are nearly $10 billion since early
1993. Their cumulative effect has resulted in increased media
discourse on the dangers of derivatives and signalled an alarm
in the corporate sector. These headlines have also acted as an
impetus for federal authorities to examine the need for regulations
over this huge, complex, and relatively new market arena.
such headlines are proof that derivatives represent a complex
financial instrument that can result in serious financial losses.
But that should not be startling—the marketplace is by definition
filled with inherent risk. The critical questions posed by these
headlines is whether risk disclosure is necessary and whether
derivatives pose an increased systemic threat to the financial
fabric of the world sufficient to require stringent federal regulations.
Henry Kaufman states that the "new financial world is characterized
by widespread securitization of credit; by expanding internationalization
of borrowing, lending, and investing; by unprecedented volatility
in the prices of financial assets; by a decline in the relative
positions of traditional institutional lenders and investors
who tended to buy and hold; by the emergence of 'hi-octane' portfolio
managers with very near-term investment horizons who are willing
to use greater leverage to achieve higher returns; by an impressive
expansion of mutual funds, many of which employ derivatives or
acquire securities embodying derivatives; and by a persistent
blurring of the lines defining different types of financial institutions
and even a blurring of the lines between the real and the financial
aspects of business life.(1)
Kaufman's historical overview is quite correct as far as it goes.
But the driving force behind the growth of derivatives was not
change in the financial environment, but rather radical technological
advancement—particularly in computer science. This technological
revolution affected the entire world. The forces it unleashed
produced profound transformations in every component of civilization—from
science to finance. To be more specific, computer technology
has moved the world from the big to the little, from the vast
to the infinitesimal.
physics, we moved from General Relativity to quantum physics,
and in biology from individual cells to gene engineering. The
world's first understanding of the atom was simply as a solid
central nucleus surrounded by tiny orbiting electrons. However,
new computer technology brought a much clearer comprehension
of the complexity of the atom, its subatomic particles of electrons,
protons and neutrons, and its nucleus containing intricate combinations
of quarks. Similarly, in biology, technological advancements
taught us that cells, originally thought to be simple repositories
of chemicals, are more like high-tech factories in which complex
chemical reactions produce substances that travel via networks
markets, the evolution was strikingly similar. When advancements
in computer technology were applied to established investment
strategies, the result was remarkable. Just as it did in the
sciences, market applications went from macro to micro. Intricate
calculations and state-of-the-art analytical systems ensued,
offering financial engineers the ability to divide financial
risk into its separate components. Derivatives—the financial
equivalents to particle physics and molecular biology—were born.
The primary purpose of these instruments is not to borrow or
lend funds but to transfer price risks associated with fluctuations
in asset values.
process was initiated by the financial futures revolution in
1972. The Chicago Mercantile Exchange recognized that futures
market risk-transfer mechanisms applicable to agriculture were
equally relevant in finance. The International Monetary Market
thus was launched with the express purpose of developing futures
trade in financial instruments. This revolutionary innovation
created the first broad-based risk management products and ushered
in the Era of Financial Futures. Modern academic theory then
acted as a catalyst in the process by fostering the principle
of risk management as a necessary business regime. Thereafter,
evolution in world economies, as Mr. Kaufman noted, transformed
these relatively simple tools into the present genre of complex
engineers using their computers began to comb world markets searching
for inefficiencies, financial exposure, and investors' dilemmas,
to create synthetic financial instruments to solve the perceived
risks. Consequently, an infinite number of derivative products
were created whose values depend on the value of one or more
underlying assets or indices of asset values. Simple futures
contracts in foreign exchange, Eurodollars, and bonds evolved
into complex swaps and swaptions, strips and straps, caps and
floors. Investment methodologies were transformed from all-encompassing
traditional strategies to finely-tuned modern portfolio theories;
long-term hedging evolved into on-line risk management.
today are applied within two separate regimes: Over-The-Counter
(OTC) derivatives—traded privately among banks and their large
corporate and institutional customers; and Exchange-traded derivatives—financial
and commodity futures and options. Combined, these two sectors
represent a multi-trillion-dollar market. The OTC derivatives
market now greatly overshadows exchange-traded instruments, however,
it lacks the protective components of the 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 products generally also lack the
regulatory control of federal authorities to which futures and
options exchanges are subject.
evolution is the offspring of necessity—derivatives have grown
because they are essential. Today's world offers a highly complex
and hazardous economic environment where competition is global,
financial volatility is continual, and opportunities rapidly
appear and disappear on a constantly changing financial horizon.
Today's world demands cost-efficient instruments that can protect
from inherent financial risks, adjust portfolio exposure between
securities and cash, hedge against interest rate and exchange
rate exposure, manage assets and liabilities, enhance equity
and fixed income portfolio performance, and protect against commodity
price rises or mortgage interest expense.
a result of derivatives application, risks are reduced, losses
are minimized, and profit is increased over a wide sphere of
financial enterprise—these positive results go mainly unreported
in the media. And the constructive effects go far beyond direct
benefits to the private sector. Both exchange-traded and OTC
derivatives foster rapid growth in international trade and encourage
capital flows. These instruments serve to funnel excess savings
from mature industrialized countries into higher yielding opportunities
in developing nations. By providing the means to manage risk,
financial derivatives reduce the cost of capital, thereby facilitating
investment, economic growth, and the raising of living standards.
the foregoing does not imply that derivatives are a panacea for
the world and without risk to the user. The recent report of
the U.S. General Accounting Office (the GAO Report) correctly
enumerates four sets of risks posed by derivatives:
risk. The exposure to the possibility of loss resulting
from a counterparty's failure to meet its financial obligation;
risk. Adverse movements in the price of a financial asset
risk. An action by a court or by a regulatory body that
could invalidate a financial contract; and
risk. Inadequate controls, deficient procedures, human
error, system failure, or fraud.(3)
most widely recognized report on derivatives—The Group of Thirty
(G-30) chaired by former Federal Reserve Board chairman Paul
Volcker—concluded that: "Derivatives by their nature do not
introduce risks of a fundamentally different kind or of a greater
scale than those already present in the financial markets. Hence,
systemic risks are not appreciably aggravated."(4) In
other words, dividing risk into its basic components does not
create a greater quotient of risk than what was already present.
present Chairman of the Fed, Alan Greenspan, and the CFTC reached
a similar conclusion and rejected the notion that derivatives
require fundamental changes in regulatory structure. In testimony
before Congress in 1994, Alan Greenspan, generally praised derivatives,
stating "The Board believes that the array of derivative products
that has been developed in recent years has enhanced economic
efficiency. The economic function of these contracts is to allow
risks that formerly had been combined to be unbundled and transferred
to those most willing to assume and manage each risk component
. . ."(5)
course, like many things in life, derivatives will not always
accomplish their intended objective. Things go wrong, bad judgments
are made, or the unexpected intervenes. But let us put this into
perspective. Are the headlines I first noted truly representative
of the results by end-users of derivatives? I highly doubt it
since such a conclusion is completely inconsistent with the incomparable
growth of derivatives. In truth, profits from derivatives—and
particularly prevention of loss to core business by reason of
derivatives—far outweigh the headlines about losses. But we seldom
hear about it. It is estimated that OTC derivatives market grew
from about $1 trillion in 1987 to perhaps $10 trillion of underlying
contract or notional principal amount now outstanding to end-users.(6) The
exact amount is actually hard to determine because of the substantial
potential double-counting of intra-dealer transactions. But whatever
the gauge, the market growth of OTC derivatives has been phenomenal.
derivatives today are a mainstream element of the global banking
business and a major source of earnings for approximately 150
of the world's largest commercial banks and securities firms
which are active dealers in these markets. The headlines we read
represent a distorted view of derivatives. And not all the headlines
we read about derivatives have anything to do with derivatives
risk. Stories about losses resulting from trading in futures
or unreported losses in OTC instruments abound; unfortunately,
the headlines caused by such stories are intermingled in the
media with the risks derivatives pose, when in fact such losses
represent nothing but garden-variety unauthorized speculative
activities that have been around since the beginning of markets.
it's Mexico or Barings, these problems reflect inadequate monitoring
and supervision," says Henry Kaufman. In the easy-money boom,
too many securities executives lost the ability or will to scrutinize
high-energy traders or guard against unethical salespeople. Too
many bankers and CFOs neglected to ask whether they understood
the complexity—or the downside—of the highly leveraged derivatives
they were using to hedge financial risks. And as an influx of
some $300 billion in foreign portfolio money sent stock and bond
markets soaring in developing countries, too many investors and
fund managers stopped asking basic questions about disclosure,
accounting, value, and risk.(7)
emphasizes the need for internal controls by private sector firms.
I wholeheartedly endorse private sector implementation—by dealers
as well as end-users—of sound risk management practices as recommended
by the G-30 Report and the Federal Reserve. Specifically:
The use of derivatives in a manner consistent with the overall
risk management and capital policies approved by boards of directors.
The adoption of consistent counterparty credit limits.
The adoption of a procedure of marking positions to the market.
The use of a consistent measure to calculate daily the market
The conduct of regular simulations of stress-tests.
also wholeheartedly support regulations which require full disclosure
and comprehension of the risks inherent in OTC derivatives when
offered for investment or speculative purposes to the general
public—just as they are required in regulated futures. Derivatives
do not represent a traditional investment class with which the
public is generally familiar. Rather, they embody complex and
sophisticated instruments of modern finance—best employed in
risk management techniques.
OTC market community must recognize that the need for stricter
internal controls is imperative and that more education and disclosure
is necessary. Indeed, the notoriety received by the headlines
has served the important purpose of energizing industry leaders
to act responsibly or face the onslaught of burdensome federal
regulation. Unfortunately, these headlines may also serve to
unduly frighten boards of corporate end-users. This could prove
disastrous. Indeed, if corporate boards refrain from prudent
use of derivatives because of fears of consequential losses to
their corporate bottom line, wait until those boards see the
reduction in their corporate bottom line as a consequence of
abstention from derivatives application.
must never forget that the quintessential element in the evolution
of mankind has been its ability to invent and innovate. It is
this remarkable capability of the human race that has enabled
it to advance so rapidly from the invention of the wheel to space
exploration, from hieroglyphics to word processors, from healing
with leeches to quadruple by-pass heart surgery. This astonishing
progression has one common denominator critical to its success:
the freedom of individuals to experiment and invent without government
interference. At every juncture in the invention process, government
involvement, with the best of intentions, could have diverted,
delayed or even destroyed the ultimate successful evolutionary
consequence of the human mind. For often as not, the original
idea is not the most important result. Indeed, inventions are,
by definition, primitive at birth, and their consequential value
becomes known only after extensive use and improvement. That
is possible only when government regulations do not unduly interfere
in the process.
no mistake about it: The value of derivatives is not an imaginary
notion. These instruments are not a selective luxury that can
be done without. If the use of financial derivatives as a hedge
mechanism is excessively restricted, the consequences to the
world's financial fabric will be much harsher than anyone realizes.
In our global market environment—driven by constant and changing
market risks, instantaneous information flows, and sophisticated
technology—derivatives are an essential instrument of finance.
They are indispensable in the management of risk and of immense
benefit to a nation's economy.
Kaufman, "The Supervision of Financial Derivatives," The
Journal of Derivatives," Fall 1994.
Siegfried, "Discoveries," Dallas Morning News, 14 December
U.S. General Accounting Office Report, "Financial Derivatives:
Actions Needed to Protect the Financial System," May 1994.
of Thirty, "Derivatives: Practices and Principles," July 1993.
Alan Greenspan, Chairman, Federal Reserve Board, Subcommittee
on Telecommunications and Finance, Committee on Energy and Commerce,
U.S. House of Representatives, 25 May 1994.
General Accounting Office (GAO) Report on Financial Derivatives,
submitted to Congress on May 18, 1994.
Week, "The Lesson from Barings' Straits," 13 March 1995,
to top of page | Return to
Index | Home Page