Are Derivatives Weapons of Mass Destruction? (Part 3 of 3)

By: Siyanda Pali

There have been several fatalities of unregulated OTC derivative speculation. We saw the demise of Barings Bank in 1995, the implosion of hedge fund Long Term Capital Management (LTCM) in 1998, Enron’s bankruptcy in 2001, which was later followed by the fall of AIG, the collapse of Investment Bank Bear Stearns in 2008, as well the downfall of Lehman Brothers.

The above events, even prior to the failure of AIG, Bear Stearns and Lehman, are the unfortunate backdrop to the statement made by Buffett. Whether or not Lehman should have been allowed to fail is a debate which still needs serious attention. In his letter, he warns about the imminent systemic risk derivative speculation causes to society. This is the result of, inter alia, an innate characteristic of derivatives, leverage, which, when coupled with unchecked speculation, exponentially increases the moral hazard to society. The likes of Long Term Capital Management used one such derivative, namely a Total Return Swap, a contract which facilitates 100% leverage in various markets. This is an example of the mockery made of margin requirements by some derivatives. When such speculative trades which are highly leveraged go unchecked, the financial system is bound to self-destruct due to large sums of money being susceptible to loss by institutions abruptly. This then, in a worst case scenario, has the potential to cause a ripple effect of failing institutions which, if rescued by central banks, are rescued at the expense of the taxpayer.

One may ask, however, how much of the derivative market was composed of speculation and hedging respectively? December 2008 International Bank of Settlements data shows that the Credit Default Swap market came in at a notional value which topped $67 trillion US. However, the total market value of all bonds issued by US companies equalled $15 trillion US. This means that the notional value of the Credit Default Swap market in 2008 was 300% greater than that of the underlying, a certainty that the market was dominated by speculation.

Does this, then, mean that speculation in its entirety is poisonous to financial markets? On the contrary, it has a range of positive functions. According to Professional Investor Benjamin Graham, known as the Father of Value Investing, coincidentally mentor to Warren Buffet, speculation performs 2 important functions. Firstly, the allure of making long-term gains of wealth can be realized by a speculator. Speculation, as stated in Graham’s classic, The Intelligent Investor, is “the oil which lubricates the machinery of innovation”. Small, untested companies such as then Edison General Electric Company, which sent electric light into US homes, and Amazon, a behemoth which sells a vast amount of goods online, would not be able to raise the capital necessary to expand operations and to grow without speculation. Secondly, speculation plays a key role as a means of transferring risk. A buyer of a stock absorbs the risk of the share price decreasing, while the seller of a stock incurs the risk of a loss of investment gains should the share appreciate in value. Speculation also facilitates the process of managing risk for unknown future activity. The reason why prices do not remain constant is because the underlying factors are not static either. Farmers, for example, will be much more likely to produce a crop despite this level of uncertainty if speculators are willing to bear the risk at a given price. Thus, speculators encourage production by taking on risk. Speculators such as some hedge funds are also likely to find other factors eg. environmental factors, which are not reflected on company balance sheets, which may be of vital importance in determining company performance, thereby actually contributing to better reflecting true company and market operations.

Richard Sandor, the Father of Financial Futures, in his offering, Good Derivatives, makes a compelling case for why derivatives play such a meaningful role in society. This Financial Innovation pioneer makes a strong case for his claim by highlighting the use of emissions trading to combat acid rain, arguably one of the most successful environmental programs to date.

Derivatives also promote efficiency in markets. This efficiency then, allows participants to take advantage of opportunities which would otherwise be unavailable to them. A good example of this is a home mortgage, which allows an individual of moderate means to be able to enjoy home ownership, despite not having paid the full amount for a property. This is possible as long as they are able to pay a margin on a monthly basis.

Honest, hardworking citizens should not be left with the burden of contributing, through the fiscus, their hard-earned income to correct the wrongs of financial institutions. This is why Basel 3, a significant piece of legislation, produced by the aforementioned Basel Committee, in line with the Basel Accord, was enacted in 2013, to limit the chances of another financial crisis. Before one looks at the abovementioned legislation, it is a good idea for one to outline the landscape prior to its enactment.

The above graph shows bank assets as a percentage of GDP for selected countries between 1870 and 2008. This graph achieves two main roles. Firstly, it highlights the magnitude of bank assets as a percentage of GDP of some countries, which has risen steadily to astounding levels, an average 200% for some countries. Secondly, it highlights how important the quality of bank assets is. Risk Management invariably becomes critical in maintaining healthy global financial markets.

Basel 3 advocates for 3 main changes to be made in banks. The first, capital requirements, states that banks need to boost their risk-weighted asset reserves from 2% to at least 7%. The second is a limit on the leverage ratio banks may use, regardless of which assets are being bought. The third is a liquidity requirement which will ensure that banks remain afloat, even during high-stress periods, for up to 30 days of trading. If all the above enjoy global implementation, a more robust financial system should be realised.

And so the question arises: are derivatives weapons of mass destruction? Derivatives have been in existence for centuries and have played a critical role in the establishment of many an exchange around the world. They play a key role in society as a hedging instrument which reduces the risk of respective individuals. Another useful element incumbent in derivatives is the promotion of efficiency, which allows individuals to profit from opportunities which would otherwise be unavailable to them. Unchecked derivative speculation, however, increases the systemic risk because large amounts of money can be very quickly lost by institutions. This then creates a negative externality, in its zenith, a snowball effect, the failure of financial institutions which ultimately, are bailed out at the expense of the taxpayer. It is therefore of critical importance for derivatives to be regulated, as has been the case for centuries, prior to the UK’s Financial Services Act of 1986 and Wall Street’s regulatory exemptions which culminated in the CFMA of 2000, as a safety precaution against any future derivative-related diabolical event. The answer to the above question is that the advantages of derivatives cannot be discounted. However, derivatives are financial weapons of mass destruction only as long as they are deregulated and appropriate risk management tools are not employed by users. Loyalists of Adam Smith will have to reconsider their stance as far as this market is concerned due to its dynamic and ubiquitous nature.

In William Shakespeare’s ‘As you like it’, he makes a poignant and relevant point regarding this market. “The world’s a stage, and all the men and women merely players”. Therefore, investors will be investors, large institutions will be large institutions, Fund managers will be Fund managers and citizens will be citizens. It is incumbent upon regulators to play their part, for the well-being of global financial markets.

Perhaps the greatest irony of all is the fact that Berkshire also had derivatives on its books in 2002. However, they also made sure that they held cash…just in case. Under the stewardship of Warren Buffet and Charlie Munger, Berkshire Hathaway A shares as of 27 January 2015 were listed on the New York Stock Exchange at a cool $221 511 US each, an estimated R 2,2 million a share.

                                                                      References

1. Graham, B. (1949) Rev. 2006, The Intelligent Investor. Harper Business
2. BUFFETT, W. (2002) Warren Buffett’s Letters to Berkshire Shareholders. [Online] Available from: http://www.berkshirehathaway.com/letters/2002.html. [Accessed:15 October 2014]
3. Sandor, R (2012) Good Derivatives, Wiley Publishers
4. International Bank of Settlements [Online] Available from: www.bis.org/statistics/derstats.htm (Accessed 28 January 2015)
5. Cox, R (2015) Speculation. [Online] Available from: www.referenceforbusiness.com/encyclopedia/Sel-Str/Speculation.html. [Accessed: 28 January 2015]
6. Block W, (1 December 1981) Foundation for Economic Education. Available from: fee.org/freeman/detail/the-benefits-of-speculation (Accessed 28 January 2015)
7. International Bank of Settlements (2015) Basel Committee on Banking Supervision, Basel 3 [Online] Available from: www.bis.org/bcbs/basel3.htm. (Accessed 28 January 2015)
8. The Economist (7 September 2013) The Origins of the Financial Crisis. [Online] Available from: http://www.economist.com/news/schooolsbrief/215834-effects-financial-crisis-are-still-being-felt-five-years-article. [Accessed 15 October 2014]