Traditionally derivatives were a risk management tool, protecting against unforeseen events. Now they are often seen as 'get rich quick' schemes, and the results can be disastrous.
The £700 million squandered by hapless trader Nick Leeson, when he brought down Barings bank earlier this year, was just a drop in the ocean. Others have lost untold billions betting on derivative securities: Procter & Gamble, Allied Lyons, Metallgesellschaft, Citicorp, California's affluent Orange County, even investment wizard George Soros. In 1994 Merrill Lynch, Wall Street's biggest stockbrokers, bought a super computer in an effort to ensure it wouldn't happen to them. In May of this year a worried Chase Manhattan shut down its worldwide futures trading operation.
Some, with fingers badly burned, may be wiser as well as greyer. But their setbacks look unlikely to stem the rise in derivatives trading which has grown into a $12,000 billion gambling casino in the United States alone. That's more than three times the total assets of all US banks.
But what are these so-called derivatives, and what makes them so lethal? Essentially, they are a form of bet that the value of an underlying security - which may be a share, bond, currency, commodity, even the interest due on a credit card or mortgage - will be worth a certain sum on a certain date. Derivatives usually take the form either of futures or of options. Futures oblige their holders to buy or sell the underlying security at a specific date, while options - as the name implies - grant the right to buy or sell. Option holders thus have a fixed downside (the cost of the option) but an open-ended upside. Those who write the options see the other side of that coin. They may be comforted by the knowledge that the majority of options - an estimated 80% - expires worthless, but they are under an obvious temptation to limit their exposure further by buying futures. Thus begins the complicated interweaving of different derivatives.
'Derivatives only redistribute wealth,' says Mthuli Ncube, a Cambridge PhD who lectures at the London School of Economics. 'They have nothing to do with wealth creation. But many companies have no choice but to deal with them.' In an increasingly global economy, manufacturers buy derivatives in an attempt to stabilise the future value of their imports and exports and the value of currencies in which they trade. Petrochemical and mining operations need to hedge against the risk that prices will fall before their commodities can be brought to market. Even governments buy them to help safeguard the value of their foreign reserves.
Used sparingly and responsibly, derivatives are valuable risk management tools, protecting an investment portfolio against both cyclical pressures and unforeseen events. But of course there's another reason for betting on derivatives: the eternal temptation to get rich quick. Because an option, future or other derivative can be bought for a fraction of the value of the underlying security from which it is derived (usually 5-8%), the speculator can take a much larger position than would normally be possible with any given capital base. This can bring big profits or, if the investor guesses wrong, bigger losses than can be paid back.
The most complex derivatives are customised products designed to meet specific needs. The highly structured financial deals they represent can mean taking bets on equities and bonds over a number of timescales, at the same time forecasting interest rates and the relative values of three or four currencies. These 'over-the-counter' (OTC) derivatives are far more difficult to understand or control than the exchange-traded options, futures and swaps that Nick Leeson bet the bank on. If it's easy to lose big money on exchange-traded derivatives, it's even easier with OTCs. Yet the latter now account for about half the world's derivatives market.
The big OTC deals are normally put together by an investment bank or other financial intermediary. Typically, a company will inform the bank that it wants to hedge against certain risks, such as overseas currency exposure, interest rate movements or future commodity requirements. The bank then constructs a web of derivative contract deals, and searches out counterparties with which to sign them. Understandably, the banks oppose further regulation of OTCs, since they earn huge fees for designing and arranging these deals. But even the banks don't always properly understand the instruments they create. 'Some of this stuff is so complicated it virtually requires a rocket scientist to understand it,' observes mathematician Ncube. 'Senior managers - even a lot of traders - don't have a clue.' Many of those who play with OTC derivatives are well out of their depth. Investment banks seek out doctorate-level mathematicians and pay them huge salaries to generate the baroque formulae which go into derivative risk analysis. But even the most advanced knowledge of maths and economics will not prevent things going wrong. Even masters of the game George Soros and Michael Steinhardt lost massively when the Federal Reserve increased interest rates in March 1994, and the prospect of inflation reared its head for the first time in years. By his own account, Soros lost $600 million on derivatives in one day when panic struck and the bond market crashed. If geniuses like Soros get it wrong, what chance has the average institutional investor or corporate treasurer?
Ironically, the hotshot derivatives traders who sometimes get their banks into trouble are heavily motivated to do so. The investment banks generally refuse to sign long-term contracts with traders - the average contract for unproven talent is six months - encouraging them to strike big winnings before their contracts come up for renewal. Success is rewarded by heady bonuses, while the worst that can happen (unless the law has been broken) is that the trader gets fired.
'The current system encourages traders to take big risks,' affirms Andrew Hilton, director of London's Centre for the Study of Financial Innovation. 'They generally think it's worth it because they can become rich overnight. It's bizarre to contemplate a system where the trader is actually encouraged to take a position that can destroy the institution which employs him.' How differently might traders approach the job, Hilton wonders, if they were on contract for five years instead of six months.
True, some investment banks are trying to reduce the risk that one of their own traders might 'take them out' in a zealous grab for higher yield. Salomon Brothers has tightened up its monitoring procedures and now offers smaller bonuses and bigger salaries to its 150 managing directors worldwide. 'Any trade I make is likely to be checked by 15 people within a few hours,' reports Nigel Morris-Jones, Salomon's chief derivatives analyst in London. JP Morgan and some British merchant banks are said to be introducing similar measures. But a lot of 66e market watchers are not sanguine about the scope and pace of reform. 'Sooner or later we'll see a real catastrophe, far greater than what happened to Barings,' predicts one UK funds manager. 'The banks are just greedy.' The emergence of corporate treasuries as profit centres could be a bigger danger. The disasters at Procter & Gamble, Metallgesellschaft and Orange County occurred in part because corporate treasurers were buying derivatives in search of higher returns on their investments. Their plans backfired. Hilton believes that unscrupulous hedge funds managers are selling high-risk derivatives to corporate treasurers, knowing what the consequences might be. 'Some of these investors look a lot like Lloyd's names,' says Morris-Jones. 'Some fund managers have intentionally gone looking for suckers who don't know better.' Even seasoned investors have been surprised to find how often derivatives deals are financial houses of cards built on borrowed funds. Michael Hyman is a London-based fund manager with 14 years' experience in finance, the last seven running his own funds. 'I had no inkling of the scope of the leveraging going on,' he says, referring to the situation in many hedge funds in 1994. 'I thought they were leveraging maybe 25% to 30% of their asset base. I had no idea they were really on 500%.' Experts argue about the extent to which leveraging increases the risk and volatility of the underlying investments (see box on previous page). But if a buyer defaults on the contracts, neither the financial intermediary nor any securities exchange is obliged to pay the 'winner'. This raises the possibility that a huge default might badly undermine confidence in the global financial order.
The disasters of 1994 may have encouraged more prudent investment and better management of risk. The UK and US governments are considering legislation that would increase the capital adequacy requirements underpinning derivatives positions. 'It's hard to sell leveraged positions today, even to those that did well in the past,' says Robert Benson, head of Midland Bank's Specialised Derivatives Group. 'Volumes are lower so far this year and the size of the typical deal has fallen.' Despite these encouraging signs, Benson believes human nature will eventually turn many corporate investors back towards the danger zone. 'Undoubtedly, corporate treasurers are being a lot more sensible, but they'll become adventurous again just as soon as the world economy provides the right opportunity.' Fading worries about inflation and the return of the bull to both Wall Street and the City may provide such 'opportunities' to the unwary. Dazzled by the Dow Jones' leap from high to record high over the past three months, many investors are pouring money into securities markets in an effort to make a killing before inflation returns and the current economic cycle comes to an end. If they guess the end point wrongly, those with highly leveraged positions will be forced to unwind some huge derivatives stakes in a hurry. That could destabilise the underlying markets.
'It has to be true that there is more volatility,' insists Crispin Odey, head of Odey Asset Management, another London fund that suffered last year. Odey now refuses to borrow money. 'My guess is that we have about nine more months of fun ahead of us, and then it will turn nasty,' he confides. 'Consumers will start to borrow just to blow money. Leveraging will get out of hand. Investors are going to get it wrong again.' The bull could turn thoroughly bearish this autumn as massive borrowing, fuelling an investment boom, begins to create new inflationary pressures. If interest rates have to be pushed up rapidly to contain inflation then both the equities and bonds markets could collapse, leaving some investors with huge derivatives positions facing a very ugly reality.