Derivatives: The risks and rewards
John Vahey, Lauren Oppenheimer,
The first confirmed case of speculation on derivatives goes back to ancient times, when Aristotle reported how the philosopher Thales the Milesian used his knowledge and wisdom to benefit from the leverage effect of options to carry out speculative transactions.
While there is always more speculation fed by excess liquidity compared to what would be the counterpart of physical sales whose prices have to be guaranteed, Bertrand Munier, Chief Economist at momagri, points out that there is “first the ‘useful’ speculation, a usual speculation that should not exceed three or four times global crops. Then there is the ‘excessive’ speculation.” The growing and acute financialization observed in the past decade has encouraged the expansion of excessive practices in a context of structural volatility and unpredictability. The OTC derivatives market might thus present a systemic risk that is underestimated by the financial system, and whose consequences can be particularly destructive, especially concerning agriculture and food security.
We highly recommend the article published by the American think tank Third Way, which we are excepting below1. While presenting the derivatives market, its functions and benefits, the paper warns of its potential danger. Quoting Warren Buffet who speaks of derivatives as “financial weapons of mass destruction”, the authors revisit the operations of financial companies––such as AIG––which prompted the unprecedented economic turmoil of 2008. Since then, the efforts to regulate the financial system are real, both in the United States and in Europe, but a victory in the fight against market misuses and excesses is far from assured.
momagri Editorial Board
In 350 B.C., Aristotle wrote of Thales the Milesian and “his financial device.” Thales, anticipating a strong olive harvest, paid olive press owners a fee to secure the rights to their services during the upcoming harvest. When the olive harvest was huge, demand for olive presses soared, and Thales sold the rights to the presses to the highest bidders and made a fortune. The “financial device” that Aristotle’s story described was, in fact, a derivative—possibly the first recorded derivative trade.
The danger of derivatives
In a 2002 letter to Berkshire Hathaway shareholders, Warren Buffett warned investors about the “latent” problems in the over-the-counter derivatives market. He expressed the view that, due to multiple shortcomings with how the market functioned, derivatives were “financial weapons of mass destruction.”
Two of the specific weaknesses Buffett’s letter cited were: an abundance of bilateral credit risk—or the risk that a counterparty to a trade would be unable to meet its financial obligations—and a lack of margin collateral in place to cover potential losses.
During the financial crisis, these deficiencies became painfully evident, especially in relation to the derivatives trades of AIG.
A subsidiary of AIG, AIG Financial Products (AIGFP) had sold CDS on mortgage-related investments. AIG’s risk was that the value of the underlying mortgages would decline. When the housing market collapsed, losses on AIG’s derivatives caused AIG’s financial health to deteriorate. Derivative counterparties began to question the ability of AIG to honor its derivative-related financial obligations.
AIG’s credit rating was downgraded. As a result of AIG’s failing economic health derivative counterparties demanded that AIG provide collateral to account for the declining values of their derivatives trades.
Eventually, in 2008, derivatives losses and demands for additional collateral overwhelmed AIG. The Federal Reserve, fearing that the failure of AIG would have dire systemic consequences, stepped in and provided $85 billion in capital.
Warren Buffett’s warnings about the derivatives market had come true. Large uncollateralized derivatives positions had created a historic economic disturbance. The Dodd-Frank Act sought to address Mr. Buffett’s concerns, and the shortcomings in the derivatives market that AIG’s derivatives failure painfully exposed.
Reduction of bilateral Credit Risk
Dodd-Frank fundamentally restructures the derivatives market. To address an overabundance of credit-risk relationships, Dodd-Frank requires certain standardized swaps to be submitted to and cleared through a central counterparty (CCP).
The CCP, instead of a bank, stands between the two trading counterparties and guarantees the performance of the trade. This reform centralizes the credit risk of the swaps market into centralized clearing entities. This centralization stands in contrast to the myriad tangled swap agreements prior to Dodd-Frank.
In a recent speech, Federal Reserve Board Governor Jerome Powell noted the potential benefits of centralized clearing for market participants. “Rather than trying to assess its exposure to all of its trading partners, a market participant would need to manage only its exposure to the central counterparty.”
Since 2008, a sizeable portion of interest-rate swaps trading has migrated to CCPs. As former Commodity Futures Trading Commission (CFTC) Chairman Gary Gensler stated in a December 2013 speech, “Reforms have taken us from only 21 percent of the interest rate swaps market being cleared five years ago to more than 70 percent of the market this fall.”
In a centrally cleared trade, if one of the counterparties to the trade becomes unable to make good on their financial obligations, the CCP steps in and makes the required payment.
This is the system that has long-existed in the exchange-traded futures and options market. In that market, trades between market participants are submitted to and guaranteed by a clearinghouse. The clearinghouse monitors the financial health of each clearing member to ensure that they are able to meet their financial obligations.
Margin is collateral, cash or securities, that is in place to cover potential trading losses. The Dodd-Frank Act requires CCPs to collect margin in relation to cleared swap trades.
As Buffett’s 2002 letter states, “Unless derivatives contracts are collateralized or guaranteed, their ultimate value depends on the creditworthiness of the counterparties to them.”
For cleared swaps, CCPs will be responsible for collecting initial margin. And the CCP will then monitor the exposure of each cleared trade and mark each position to market daily.
If the swap value drops, the participant whose position value has decreased will be required to deposit additional margin—known as variation margin—to re-establish an adequate buffer of margin capital.
Dodd-Frank now requires this practice, which has long been standard in the futures and options market, in the swaps market. This requirement ensures that the parties that enter into swaps trades have capital in place to absorb losses—if losses should occur.
The margin requirements contained in Dodd-Frank significantly reduce the risk that the derivatives market poses to the financial system. The existence of CCPs will ensure that mark-to-market losses on cleared swap exposures are reconciled swiftly.
The derivatives market is a market where investors come to exchange risks. In a global economy with divergent risk exposures, derivatives allow businesses and investors to protect themselves from rapid price fluctuations and negative events.
Prior to the crisis, the swaps market was not subject to an effective regulatory regime. There was an over abundance of bilateral credit risk and trades were under-collateralized. As the collapse of AIG demonstrated, this inferior market structure quickly became a source of risk.
As the regulatory process continues, policymakers must seek to ensure that the derivatives market is a venue to manage risk, rather than a source of risk itself.