THE DOWNSIZING OF RISK

Published in China Futures
25 April 1995

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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.

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Headlines 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.

Clearly, 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.

Economist 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)

Mr. 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.

In 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 of fibers.(2)

In 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.

The 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 derivatives.

Financial 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.

Derivatives 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.

Investment 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.

As 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.

However, 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:

1. Credit risk. The exposure to the possibility of loss resulting from a counterparty's failure to meet its financial obligation;

2. Market risk. Adverse movements in the price of a financial asset or commodity;

3. Legal risk. An action by a court or by a regulatory body that could invalidate a financial contract; and

4. Operations risk. Inadequate controls, deficient procedures, human error, system failure, or fraud.(3)

The 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.

The 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)

Of 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.

OTC 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.

"Whether 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)

This 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:

1. The use of derivatives in a manner consistent with the overall risk management and capital policies approved by boards of directors.

2. The adoption of consistent counterparty credit limits.

3. The adoption of a procedure of marking positions to the market.

4. The use of a consistent measure to calculate daily the market risk.

5. The conduct of regular simulations of stress-tests.

I 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.

The 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.

We 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.

Make 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.

____________________

     (1) Henry Kaufman, "The Supervision of Financial Derivatives," The Journal of Derivatives," Fall 1994.

     (2) Tom Siegfried, "Discoveries," Dallas Morning News, 14 December 1992.

     (3) The U.S. General Accounting Office Report, "Financial Derivatives: Actions Needed to Protect the Financial System," May 1994.

     (4) Group of Thirty, "Derivatives: Practices and Principles," July 1993.

     (5) Testimony, Alan Greenspan, Chairman, Federal Reserve Board, Subcommittee on Telecommunications and Finance, Committee on Energy and Commerce, U.S. House of Representatives, 25 May 1994.

     (6) The General Accounting Office (GAO) Report on Financial Derivatives, submitted to Congress on May 18, 1994.

     (7) Business Week, "The Lesson from Barings' Straits," 13 March 1995, p. 30.

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