Derivative Securities
“Derivatives are time bombs, both for the parties that deal in them and the economic system. Derivatives are a threat to global financial stability.”
In this dynamic business environment, more and more creative financial instruments are developed in the market and one of the important financial instruments in today’s market is derivatives. However, due to the disaster it has created, for example, Enron’s bankruptcy and the near-bankruptcy of Long Term Capital Management. Some people are now arguing that derivatives are time bombs for both the parties that deal in them and the economic system, which is threat to global financial stability. By contrast, someone says derivatives have improved economic stability, arguing that they allow companies and others to hedge against unfavorable economic developments. Who’s right?
In my point of view, whether derivatives are time bombs depends on how they are used.
When used properly, this goal is met. But if they are not used for managing risk but as a tool to speculate or even to make fraud, they can be time bombs.
In the following, we will investigate the arguments against and for derivatives. Finally, we will have a conclusion.
The first argument against the use of derivatives is the complexity of accounting rules for derivatives can lead to overstatements of profits and confusion. Normally, before derivatives position is settled, the parties dealing with the derivative would record profit and losses which are in huge amount in most case.
Since today’s earnings are mostly based on estimates, reported earnings on derivatives are often wildly overstated. The two parties to the derivative contract might well use different models allowing both to show substantial profits for many years. They use mark-to-model to account for the values of the derivatives, but often there is no real market. This discretionary accounting method often makes financial statement to be misleading.
For example, the US energy market, which relied for most of its deals on derivatives trading and resulted in the collapse of Enron.
Another argument is derivatives magnified the problem for companies having credit problem. A company which has a credit problem typically has to put up more collateral against its derivatives contracts. This would paralyze the operation of the company since their assets are ‘frozen’ by the derivatives contracts. Putting up more collateral could make the company having liquidity problem and that may trigger still more downgrades. It all becomes a spiral that can lead to a corporate meltdown. Thus, derivatives increase the risk of bankruptcy and default.
If the above arguments really exist, that is, derivatives create risks. These risks would lead to huge disaster in this globalized economic market. The close linkage in this market would create a daisy-chain risk. For example, receivable from Company A goes bad may also affect those from Companies B through Z.
This problem is obvious in banking industry since there are close linkages between banks. For example, a few big banks dominate the banking industry in U.S., seven banks in U.S. account for 96 percent of derivatives holdings. Large amounts of risk have become concentrated in the hands of relatively few derivatives dealers. The troubles of one could quickly infect the others.
Actually, derivatives themselves do not create problem. Especially for standard futures contracts such as wheat which are traded on exchanges, such as the Chicago Mercantile Exchange. This is because there are adequate supervisions over these contracts. However, there are more and more new derivatives which are traded “over the counter” could trigger a panic. This can be done through private trades rather than on public stock or commodity exchanges. This gives investment banks flexibility to propose to their customers whatever deal they want, rather than being bound by the trades sanctioned by exchange supervisors. Regulators and citizens are actually kept in the dark. Together with the lack of regulations and supervision, say, Central banks and governments have so far found no effective way to control, or even monitor, the risks posed by derivatives contracts. Then, derivatives could really become time bombs.
When looking at the argument favoring the use of derivatives, we can see that derivatives are very valuable. This is because derivatives provide methods by which risks can be shared, sliced, and diced, and given to those most willing to bear them. They add to the flexibility of the financial system in many different ways.
Since currency, equity and bond markets have high volatility and risks. Managing risks is critical for investment success. An investor may wish to avoid the risk of incurring losses on his portfolio. A speculator may wish to deliberately undertake increased risk in order to earn profits from forecasting market development correctly. Actually, derivatives enable investors to transfer unwanted risks to other market participants.
To conclude, the use of derivatives can actually stabilize the economy, facilitate trade, and eliminate bumps for individual participants on a micro level. However, on a macro level, derivatives can be very dangerous. As large amounts of risk, particularly credit risk, have become concentrated in the hands of relatively few derivatives dealers, who in addition trade extensively with one other. The troubles of one could quickly infect the others. Therefore, we need reforms to regulate these few derivatives dealers.
Recently, most discussions emphasize transparency reforms such as ensuring that any derivatives or similar trades are only done via exchanges. However, this will not suffice. The problem is not a lack of transparency of the derivatives but their complexity and the lack of controls employed by buyers and sellers. Derivatives should be treated like other financial instruments, increasing prosecutions of financial frauds, improving disclosure by moving from a rules-based to a standards-based reporting framework, and ensuring that regulations do not confer oligopoly power. Reforms will only be significant if citizens inform themselves and mobilize on these issues.
Therefore, to obtain greater financial stability, the public must reassert control and promote a banking system that acts within clear limits. And the system must be in favour of the many, rather than the few. More space should be opened to push for new forms of ownership and control over the provision and management of credit. Derivatives, the key mechanism in the shadow banking system created in recent years, must be strongly regulated.
Reference:
http://www.investopedia.com/terms/d/derivativestimebomb.asp
http://www.fintools.com/docs/Warren%20Buffet%20on%20Derivatives.pdf
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http://www.eurodad.org/uploadedFiles/Whats_New/News/Dangerous%20derivatives%202%20pager%20final.pdf