Have you ever stood between two mirrors and seen the seemingly infinite reflection of your image?
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If you look long enough, you begin to wonder which image is the original and which of the multiple copies of you is the duplicate.
It’s kind of freaky and unnerving at the same time.
This mirage is analogous to the quandary facing global policymakers grappling with the conundrum of regulating the financial derivatives market.
Derivatives are financial contracts or instruments whose prices are derived from the price of something else such as a specific commodity, stock or even a mortgage. The underlying price on which a derivative is based can be that of an asset like the price of oil or the appraised value of a trust deed.
A Variety of Applications
The concept and use of derivatives is not new. It’s been around for hundreds of years.
Farmers have used derivatives in the commodity futures markets to mitigate the risk of economic loss arising from changes in the value of their underlying crop, such as corn or wheat. This activity is known as hedging.
Alternatively, derivatives have been used by investors to take a risk and make a profit if the value of the underlying product moves the way they expect. In other words, the speculator makes money if the price of the product moves in a given direction or if it stays in or out of a specified range.
A perfect example of this latter form of investment is the oil market.
Last summer, prices swung wildly as investors on both sides of the Atlantic speculated on the values. There was no real shortage of oil in the marketplace. Rather, there was an over-abundance of speculators betting the direction of oil prices.
Although a substantial portion of these bets on the price of oil were placed through regulated clearing houses, such as the Chicago Board of Trade or the Mercantile Exchange in New York (NYMEX), an equal amount of these wagers were posted through the use of unregulated over-the-counter or OTC derivatives.
So-called OTC derivatives — bought and sold by parties outside exchanges — are seen by many as one of the key triggers of the global financial crisis that brought down some of Wall Street's biggest names.
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Derivatives such as credit default swaps, which were used by speculators to bet on the sustained underlying value of residential mortgages, contributed to almost $1.5 trillion in write-downs and losses at the world’s biggest banks. Since the start of 2007, banks and insurers like AIG have been forced to shed nearly $28.7 trillion as investors have become more risk averse amid a global recession.
Challenges to Ponder
Currently, the Bank for International Settlements estimates that worldwide, outstanding derivatives total $592 trillion or about 10 times the global gross domestic product.
Although derivatives bring substantial benefits to our economy by enabling producers and companies to manage risks, they also pose very substantial challenges.
Of particular concern, is the lack of transparency in the OTC derivative markets. This opacity, combined with a dearth of regulation, has made these markets vulnerable to fraud and unchecked price manipulation.
Nearly every financial commentator agrees that getting a firmer grip on the unregulated derivatives market is crucial to laying the foundation for a safer, more stable financial system. For this reason, regulators like U.S. Treasury Secretary Tim Geithner and his British counterpart Finance Minister Alistair Darling have been wrestling with the establishment of a comprehensive framework to monitor these complex financial instruments.
Despite the widespread agreement that derivatives have led to the downfall of so many financial institutions, banks have continued to lobby hard against tighter regulations.
In good times, the sale of derivative financial contracts was the source of enormous profit for institutions whose sole revenue previously had been limited to collecting interest and transaction fees.
With the overall lack of transparency in this market, the banks were able to make money on both ends of the transaction by maintaining generous spreads. These wider spreads, however, also led to leveraged risks as high as 50-to-1.
As a consequence, when investors sought to unwind their speculative positions on the value of underlying instruments such as a mortgage-backed security, the banks or insurance companies issuing these derivatives didn’t have the cash to cover their bets.
It was sort of like a bookie who took too much action on a 50-to-1 darkhorse in the 7th race at Aqueduct. If the nag wins, he’s not going to have the enough dough to cover the action.
If this happens to a bookie, he splits town before Bruno and the boys take their winnings out of his hide. When this happens to interconnected financial institutions like investment bank Lehman Brothers or an insurance company such as AIG, it can crash an entire financial system.
Some of the world’s otherwise most conservative financial institutions, like Switzerland’s UBS and Germany’s Deutsche Bank, got caught up in the frenzy. Even though each eventually lost billions on these derivative bets, they still are hesitant to embrace increased regulatory oversight.
When it comes to derivatives, the world’s banks are like heroin addicts. Now that they’ve gotten a taste for the potential profits from these risky bets, they’re reluctant to give up the high.
John Cohn is a senior partner in the Globe West Financial Group, based in West Los Angeles. He may be contacted at www.globewestfinancial.com
