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CFA Society Philippines > Capital Market > 20080805_derivatives  

The Benefits and Dangers of Derivatives for a Developing Economy

 

When the renowned investment guru, Warren Buffett, called derivatives ‘financial weapons of mass destruction’ in his letter to shareholders of Berkshire Hathaway in February 2003, not many people understood what he meant. Then came the subprime mortgage crisis in the summer of 2007, which is still ongoing one year later. The losses sustained by the US financial sector not only were borne by those engaged in mortgage lending, but by those involved in the trading of derivatives that were based on the subprime mortgages, or even on the derivatives of the subprime mortgages.

 

The recent publication of the book, Capital Market Liberalization and Development by the Oxford Press could not therefore have been better timed. One chapter is particularly relevant : “Consequences of Liberalizing Derivatives Markets” written by Randall Dodd. While CFA Philippines will be launching a seminar on derivatives in September, that event is targeted at prospective derivatives users such as CFOs of corporations. This article looks at derivatives from the angle of market regulators and operators whose economic well-being are correlated with the long-term sustainable development of the capital markets in an economy.

 

Derivatives Markets in Developing Countries

 

In the beginning of the chapter, Dodd noted that “Derivatives markets are growing rapidly in developed as well as developing economies….The world’s largest derivative contract by trading volume is no longer that on the US Treasury Bond or Eurodollar interest rate, but now it is an option on the Korean stock index.” Closer to home, Dodd found data that shows that in 2004 the annual trading volume in OTC foreign exchanges derivatives for five South East Asian countries (Indonesia, Korea, Malaysia, Philippines, and Thailand) was a staggering US$3,773 billion.

 

In 2003, “(m)easured by the number of futures contracts traded, three of the largest futures exchange were in developing countries were in developing countries: Mexico’s Merder is fifth, Brazilian BM&F is ranked sixth, and China’s Dalian is ranked ninth.”

 

Dodd was alarmed by this trend. “Despite the tremendous growth in the size and use of derivatives markets, their role in economic development and their regulatory treatment have received far less attention than that for banking and securities markets.”

 

Dodd is not against the trading of derivatives. He acknowledges that derivatives serve very useful functions in capital markets. “While derivatives performed the economically useful purpose of risk shifting (hedging) and price discovery, they also created new risks that were potentially destabilizing for developing economies.”

 

As noted above, the Philippines is one of the developing countries that have a substantial derivatives market, albeit mostly in the OTC platform for corporations, instead of in exchanges that are accessible by the public. Dodd’s analysis of the benefits and dangers of derivatives to an economy is therefore relevant for financial sector participants and regulators in the Philippines.

 

Benefits of Derivatives

 

According to Dodd, derivatives complement the economic functions of capital markets, hence it is natural that they grow alongside each other. “(D)erivatives facilitated the flow of capital by unbundling risk in its component parts and redistributing risks sway from investors who did not want the exposure and towards those investors more willing and able to bear it. Data from 1992 to 2001 shows that the growth in derivatives trading volume grew and then contracted in parallel with trading in credit instruments.

 

Dodd identified two important benefits of derivatives markets to the economy. “One is that they facilitate risk shifting, which is also known as risk management or hedging. The other benefit is that they create price discovery – the process of determining the price level for a commodity, asset, index, rate, event, or other item.

 

On the first mentioned benefit, derivatives can unbundle and then more efficiently reallocate the various sources of risk associated with traditional capital vehicles such as bank loans, equities, bonds, and direct foreign investment. Examples of sources of risk associated with traditional capital vehicles are : “foreign currency loans expose the foreign investor to credit risk, and the domestic borrower to exchange rate risk; a fixed interest rate loan exposes the foreign lender to interest rate risk, and a variable rate loan exposes the domestic borrower to interest rate risks;… equities expose the foreign investor to credit risk along with the market risk from changes in the exchange rate, market price of the stock, and the uncertain dividend payment,” and so on. Derivatives allow these traditional arrangements of risk to be redesigned so as to better meet the desired risk profiles of the issuers and holders.

 

On the second benefit, we know how commodity futures prices are relied upon as a basis for determining the prices to the producer and consumer of commodities and those of their products and byproducts. “Price discovery is so important for the efficient working of the economy that it is imperative that the integrity of prices be protected.” We are all very familiar with the ongoing debate on whether the oil price futures markets are manipulated so much so that the futures prices are driving the spot prices of the actual commodities.

 

Dangers of Derivatives

 

Dodd referred to a report by Gosain (1994) that shows that “trading volume in options on developing country sovereign debt rose from $1 billion in 1989…..to $70 billion in 1993 (measured in notional value).” The Gosain report highlights an alarming trend :  Local financial institutions in Mexico, Argentina, and Brazil were buyers of call options of their own countries’ sovereign debts, while their American and European counterparts were sellers. “(D)eveloping countries, who were capital importers, were taking long derivatives positions on their own securities. That is not hedging because it does not reduce risk, rather it is taking on additional risk and is using OTC derivatives to speculate”.

 

Dodd categorizes the dangers of derivatives to the developing economies into two types. One is called ‘abuse of derivatives’, and the second is the ‘negative consequences from the misuse of derivatives’.

 

Abuse of derivatives will lead to higher capital costs due to lower trust and confidence in financial and commodity markets. Examples of abuse are fraud or market manipulation, deliberate efforts to use derivatives to evade or avoid tax, the use of derivatives to distort the information about a country’s macroeconomic conditions such as expectations about the stability of a country’s currency or sovereign credit risk.

 

Examples of abuse of derivatives include the following. “In the US, a recent survey of businesses reveals that 42 percent use derivatives primarily to ‘manage reported earnings’ such as by moving income from one period to another. Another example drawn for the US experience involves the mortgage titans Fannie Mae and Freddie Mac, which are the world’s largest hedgers, who filed financial reports which falsely understated the value of their derivatives positions by billions of dollars.” We now know how damaging such abuse of derivatives can be. They allowed these corporations to understate the risk that these corporations were taking, until matters got completely out of hand.

 

Governments are also guilty of such abuse. Several European countries used derivatives to reduce their reported budget deficits in order to meet European Union’s Maastrich Treaty restrictions on fiscal balances.

 

There are as many derivatives as there are traditional financial instruments. “The currency denomination of assets and liabilities such as foreign loans can be changed with foreign exchange derivatives. Interest rate swaps can alter the interest rate exposure on assets and liabilities.” The advantage of using the derivatives can be the undoing of the users of such derivatives. “(D)erivative exposures can generate large, sudden cross-border transactions to meet margin calls or collateral calls, and the likelihood of these sudden flows would not otherwise be indicated by the amount of foreign debt and securities in a nation’s balance of payments accounts.” Thus, countries can mask their credit risk to investors, allowing them to take bigger risk, which in the end will only lead to ruin.

 

Another abuse of derivatives is to take advantage of the price discovery function of derivatives. Currency markets sense the future value of a currency from data in the forward and swap markets. However, occasionally, such as when market confidence is challenged, well-capitalized market operators can influence the forward and swap markets so as to distort the view regarding the future value of a currency. In the case of the attack on Hong Kong dollars’ peg to the US dollars in 1998, speculators even used the Hong Kong equity futures market in conjunction with the currency derivatives market to try to force a revaluation of the Hong Kong dollars. The attempt was unsuccessful, but the danger was real.

 

On the second category of potential dangers of derivatives markets, I think the word ‘misuse’ in the phrase ‘negative consequences from the misuse of derivatives’ should be replaced by ‘use’ instead. Reading Dodd’s text, the negative consequences are said to arise even if derivatives are being used primarily for hedging or risk management purposes. The negative consequences are caused by poorly structured and improperly regulated derivative markets. The negative consequences refer to an increase in systemic risk to the financial sector, the emergence of a risk of contagion, or financial disruption or crisis.

 

One of the potential negative consequences of the use of derivatives arises from a key feature of derivatives.  Derivatives contracts provide leverage to hedgers and speculators alike. This feature of derivatives lowers the costs of capital for taking a position, even in the context of the Basel capital requirements for banks. If a bank borrows a foreign currency loan because of lower interest rate, and then uses the proceeds to buy local corporate bonds, under Basel rules, the purchased bonds would be treated as an asset on the bank’s balance sheet and the bank would be required to hold capital against those assets. If the bank uses a total return swap to create the same investment position, the investment will be moved off-balance sheet. The capital requirements will only apply if the position has a positive present value. Since a swap’s value is the net value of the two legs of the transaction, and at initiation, its value is zero, no capital needs to be held against the asset (swap).

 

When such a risk is created for cross-border investments, derivatives can become a ‘crisis accelerator’. As an example, a bank in a developing country has entered a total rate of return swap in which it receives the rate of return on a local security and pays US dollar LIBOR plus a spread.  If the position moves against the bank, it will have to post collateral in the form of US dollars or Treasury security. If the negative move is caused by a devaluation of the local currency or a broader financial crisis, the collateral requirement would jump up rapidly, due to the leveraged nature of derivatives. The result would be massive capital outflow. This mechanism of derivatives trades is noted by Dodd as a likely explanation of the unfolding of the Mexican peso crisis in 1994.

 

Another negative consequence of derivatives trading from the angle of policy makers is what Dodd called “Conduit for Contagion”. “The presence of a large volume of derivatives transactions in an economy creates the possibility of a rapid expansion of counterparty credit risk during periods of economic stress. These credit risks might then become actual delinquent counterparty debts and obligations during an economic crisis. Investment guru Warren Buffett called this the ‘daisy chain risk’.

 

Implied in the ‘daisy chain risk’ is the potential negative consequence of derivatives coming from the high concentration of derivatives-associated risk in a few financial institutions. In the US subprime crisis, the US government has to carry out bail-outs because the financial institutions involved are considered too big to fail. Not only did the big investment banks such as Merrill Lynch, Morgan Stanley, Goldman Sachs, Lehman Brothers, J P Morgan and Bear Stearns packaged and sold subprime mortgage related derivatives to investors big and small, they also trade with each other. Hence the collapse of one of them would have dire consequences on the other investment banks. The prospect of several big investment banks failing at the same time was enough to get US policy makers to set aside the issue of moral hazard.

 

That most derivatives are allowed to be traded over the counter (OTC) also adds to the danger of derivatives to an economy. As mentioned above, derivatives allow banks to move their financial obligations off-balance sheet. Not only regulators, but the counterparties, can have no idea of how vulnerable a bank is.

 

Take Action before it is Too Late

 

The divergence in focus between market operators and public sector regulators regarding derivatives markets must be eliminated before these markets can go on a path of healthy development that will in the long run benefit both the financial sector and the economy.  Individual market operators have focused primarily on the fees that can be generated from derivatives trading for and with clients in the immediate future.  It is advantageous to them individually that the derivatives markets continue to be unregulated since this would allow more opportunities for trading. However, collectively, unfettered trading of derivatives poses severe dangers to the integrity of financial markets.

 

As evidenced by the Subprime mortgage saga, it is in the interest of the financial sector to make sure that the development of the derivatives market is done with a long term perspective and not be driven by a short-sighted quick-profit orientation; it should be even-handed so that the interest of all parties, and not just one party, are protected; it should allow sufficient transparency to allow participants and those that would be indirectly affected to properly assess the risks involved; to achieve these targets, the market should be adequately policed. The developed countries have started to improve their derivatives markets, such as by forming a central clearing house to clear derivatives, initially credit derivatives, see article here : http://www.ft.com/cms/s/0/5c6eb2e4-5f37-11dd-91c0-000077b07658.html. These measures aim to reduce OTC derivatives trades and bring derivatives trading to a more orderly platform that not only has reduced counterparty risk, but also enhanced transparency.

 

Dodd recommends that derivatives dealers and brokers be required to be registered, and that all derivatives transactions should be reported, which should include information on price, volume, open interest, put-call volume and ratios, maturity, instrument, underlying item, amounts traded and collateral arrangements. I would add that, for the major financial institutions, the amount of derivatives trading between themselves should also be monitored, so as to reduce daisy chain risk.

 

Before these improvements are made, as investors, we should be alert to the danger that countries that appear to have adequate foreign currency reserve, balanced budget and so on, may be less solid than they seem, unless these countries publicize their policy and practice regarding derivatives trading. Also, if these countries do not know how much their financial institutions are involved in derivatives trading, they may also be caught by surprise one day.

 

[Chiu-ying Wong, CFA, 5 August 2008]


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