2000, latest update 2002

Derivatives are financial contracts designed to create pure price exposure to an underlying commodity, asset, rate, index or event. In general they do not involve the exchange or transfer of principal or title. Rather their purpose is to capture, in the form of price changes, some underlying price change or event. The term derivative refers to how the price of these contracts is derived from the price of some underlying security or commodity or from some index, interest rate or exchange rate. Examples of derivatives include futures, forwards, options and swaps, and these can be combined with each other or traditional securities and loans in order to create hybrid instruments.

Derivatives play an important and useful role in hedging and managing risk, but they also pose several dangers to the stability of financial markets and the overall economy. Derivatives can also be used for unproductive purposes such as the avoidance of taxation, the outflanking prudential regulation of financial markets and the manipulation of accounting rules, credit ratings and financial reports.

As a testament to their usefulness, derivatives have played a role in commerce and finance for thousands of years. Derivatives contracts have been found written on clay tablets from Mesopotamia that date to 1750 B.C. Aristotle mentioned an option on the use of olive oil presses in his Politics some 2,500 years ago. The Japanese traded futures-like contracts on warehouse receipts or rice in the 1700s. In the U.S., forward and futures contracts have been formally traded on the Chicago Board of Trade since 1849. Today the size of derivatives markets is estimated by the Bank of International Settlements to exceed $109 trillion in outstanding contracts and over $400 trillion in trading volume on derivatives exchanges.

Derivatives are useful for hedging the risks normally associated with commerce and finance. Farmers can use derivatives the hedge the risk that the price of their crops fall before they are harvested and brought to market. Banks can use derivatives to reduce the risk that the short-term interest rates they pay to their depositors will rise against the fixed interest rate they earn on their loans and other assets. Pension funds and insurance companies can use derivatives to hedge against large drops in the value of their portfolios.

As an indication of the dangers they pose, it is worthwhile recalling a shortened list of recent disasters. Long-Term Capital Management collapsed with $1.4 trillion in derivatives on their books. Sumitomo Bank in Japan used derivatives their manipulation of the global copper market for years prior to 1996. Barings bank, one of the oldest in Europe, was quickly brought to bankruptcy by over a billion dollars in losses from derivatives trading. Both the Mexican financial crisis in 1994 and the East Asian financial crisis of 1997 were exacerbated by the use of derivatives to take large positions on the exchange rate. Most recently, the collapse of a major commodity derivatives dealer Enron Corporation has lead to the largest bankruptcy in U.S. history.

The first public interest concerns posed by derivatives comes from the leverage they provide to both hedgers and speculators. Derivatives transactions allow investors to take a large price position in the market while committing only a small amount of capital – thus the use of their capital is leveraged. Derivatives traded in over-the-counter markets have no margin or collateral requirements, and the industry standard has shown to be deeply flawed by recent failures.

Leverage makes it cheaper for hedgers to hedge, but it also makes it cheaper to speculate. Instead of buying $1 million of Treasury bonds or $1 million of stock, an investor can buy futures contracts on $1 million of the bonds or stocks with only a few thousand dollars of capital committed as margin (the capital commitment is even smaller in the over-the-counter derivatives markets). The returns from holding the stocks or bonds will be the same as holding the futures on the stocks or bonds. This allows an investor to earn a much higher rate of return on their capital by taking on a much larger amount of risk.

Taking on these greater risks raises the likelihood that an investor, even a major financial institution, suffers large losses. If they suffer large losses, then they are threatened with bankruptcy. If they go bankrupt, then the people, banks and other institutions that invested in them or lent money to them will face losses and in turn might face bankruptcy themselves. This spreading of the losses and failures gives rise to systemic risk, and it is an economy wide problem that is made worse by leverage and leveraging instruments such as derivatives. When people suffer damages, even though they were not counterparties or did any business with a failed investor or financial institution, then individual incentives and rules of caveat emptor are not sufficient to protect the public good. In this case, prudential regulation is needed – not to protect fools from themselves, but to protect others from the fools.

Another public interest concern involves transparency. Some derivatives are traded on formal futures and options exchanges which are closely regulated. Other derivatives are traded over-the-counter in markets that are almost entirely unregulated. In these non-transparent markets there is very little information provided by either the private market participants or collected by government regulators. Prices and other trading information in these markets is not readily available as is the case with futures and options exchanges. Instead that information is hoarded by each of the market participants. While standard theories of financial markets agree that more transparent markets are more efficient, it requires a public entity to require information be reported and disseminated to the market.

As a result of this lack of information in over-the-counter markets, it substantially reduces the ability of the government and other market participants to anticipate and possibly preempt building market pressures, major market failures, or manipulation efforts.

Yet another danger involves the use of derivatives to evade, avoid, dodge or out-flank financial market regulations designed to improve economic stability. In the cases of this decade’s financial crises in Mexico and East Asian, the financial institutions in those countries used derivatives to out-flank financial regulations limiting those institutions exposure to foreign exchange risk. Derivatives can also be used to avoid taxation and manipulate accounting rules my restructuring the flow of payments so that earning are reported in one period instead of another.

In sum, the enormous derivatives markets are both useful and dangerous. Current method of regulating these markets is not adequate to assure that the markets are safe and sound and that disruptions from these markets do not spill-over into the broader economy.

Some useful definitions:

· Forward contract: The original and most basic form of a derivative contract, a forward transaction is an agreement to buy or sell a certain quantity of an asset or commodity in the future at a specified price, time and place. For example, party A agrees to sell 1 million Euro in six months at $0.9402.

· Futures. A standardized agreement to buy or sell a certain quantity of an asset or commodity in the future at a specified price, time and place. They are standardized as to the quantity, the specific underlying assets or commodities and the time. Only the price and the number of contracts are negotiated in the trading process. For example, party A sells 10 contracts that set the price of the S&P500 stock index at 1500 in October – if the price falls below 1500 then party A will profit by the amount the price is below 15000, and if the price rises above 1500 then party A loses by the amount the price exceeds 1500.

· Option. An agreement that grants the options buyer the right, but not the obligation, to buy or sell an asset or commodity at a specified “strike” price on or before a certain date. A call option grants the right to buy at the specified strike price, and so it pays off if the market price for the underlying item rises above that mark. A put option grants the right to sell as the strike price and pays off when the market price falls below the strike price. On the other hand, an option seller or “options writer” has the obligation to pay when the options buyer exercises their right. Options are traded on both exchanges and OTC markets. For example, party A buys a call that grants them the right to buy 1 million Euros at $0.9400 in September.

· Forward rate agreement (FRA). An agreement to borrow or lend a certain amount of principal at a specified interest rate and time.

· Swap. An agree to swap the net value of two series of payments in which one is usually based on a fixed interest rate and the other is linked to a variable interest rate, an interest rate in another currency, the total rate of return of a security or index, or a commodity price.

· Structured note. A hybrid instrument that combines a bond or loan with a derivative. A traditional type of structured note is a callable bond.

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