November 2008

DERIVATIVES: Weapons of Mass Confusion

Fiona Rintoul seeks assurances that derivatives markets will become a safer place after the turmoil of the past year. But she’s not convinced ... There’s a slide in a humorous PowerPoint presentation about the credit crunch in which a banker says to his boss: “So you have managed to create AAA and BBB securities out of a pile of stinky, risky mortgage loans? Boss, you are a genius!”

For many people, particularly outside the industry, that just about sums up how they see derivatives and structured products at the moment. It’s certainly how they see credit default swaps (CDSs) and collaterliased debt obligations (CDOs).

Meanwhile, former Federal Reserve chairman Alan Greenspan has admitted he regrets opposing regulatory controls on some financial derivatives and that he overestimated banks’ ability to look after themselves. “I made a mistake in presuming that the self-interests of organisations, specifically banks and others, were such that they were best capable of protecting their own shareholders and their equity in the firms,” Greenspan told a congressional committee on 23 October.

It’s fair to say, then, that 2008 hasn’t been a great PR triumph for derivatives. But ‘derivatives’ is, of course, a term that covers a multitude of sins – and some things that aren’t really sins at all.

To get back to basics, Webster’s Dictionary defines derivative (noun) as “a financial instrument whose value is based on
another security”.

Sounds fair enough – and often derivatives are fair enough.

“One of the greatest dangers at the moment is that people at large and politicians will paint all derivatives as dangerous,” observes Bob Park, global CEO of FINCAD, a Canadian derivatives analytics firm that opened in Europe last year. “The reason the market grew
so quickly was that derivatives fulfil a market need and provide bona fide benefits.”

A new survey from Morse, confined to UK investment managers, illustrates how popular over-the-counter (OTC) derivatives have been even over the past turbulent year. Overall, Morse says, OTC derivative trades were up 27% on the previous year with a notional amount of $500trillion, or almost ten times the global equity market.

Of course, it’s precisely phrases such as ‘a notional amount of $500trillion’ that give people the jitters now. A friend of mine in the real world suggests words such as ‘notional’, ‘implied’ and ‘exotic’ should be replaced with ‘imaginary’ to give a clearer idea of what’s going on in certain products. Perhaps he’s right. Complex derivatives certainly can be confusing and the terminology used to describe them often seems to be designed more to obscure than to clarify.

Not all derivatives are bad, however, or overly complex, and derivatives can bring important benefits. “Derivatives have played a major role in improving the economic situation in developing markets,” notes FINCAD’s Park.

Even the products that lie behind the current problems are not necessarily bad per se. “There’s nothing wrong with the product itself,” says Subadra Rajappa, director of Quantifi, a software firm that analyses credit derivatives. “The intention of the product is to spread risk. Being able to hedge risk is an important part of trading.”

So why did things go so disastrously wrong over the past couple of months?

Park identifies the problem as lying with instruments where the risks being exchanged are not market risks but event risks,
for example mortgage-backed securities, where the risk being traded is the ‘event’ of borrowers defaulting on their mortgages.

“The models used to measure risk for these securities were completely inadequate,” says Park. “This contrasts with the models used for derivatives that exchange market risk, which are well defined, well understood and have proved to be reasonably accurate.”

At the same time, these products were being traded by what Park calls “a shadow banking system” that wasn’t regulated, allowing toxic waste to infiltrate into the system at a time of easy credit. “If you look at the CDS market, there is much more insurance outstanding against bond defaults than there are bonds,” he says. “They became a tool of speculation.”

But perhaps the biggest failure, certainly in terms of investor protection, was that of the rating agencies. Their methodology for rating CDOs was excoriated by a US congressional committee in October. “The story of the credit rating agencies is a story of colossal failure,” said Henry Waxman, chairman of the committee. “The credit rating agencies occupy a special place in our financial markets. Millions of investors rely on them for independent, objective assessments. The rating agencies broke this bond of trust, and federal regulators ignored the warning signs and did nothing to protect the public.”

Park is also scathing. “The rating agencies were using statistical models based on history, on a time before 20% of the market was sub-prime, and to compound it they issued ratings that looked like the ratings on conventional bonds.” 

Inadequate systems
Basically, the sell side was relying on models that weren’t adequate and the buy side was relying on ratings that weren’t adequate. Pretty much everyone screwed up, then, which is scary. So, where do we go from here?

“Even plain vanilla products are getting a lot of scrutiny now and there will be a lot more focus on counterparty risk,” says Rajappa. “In the past, banks were worried about exposure to hedge funds, now hedge funds are worried about exposure to banks.”

Accordingly, the next project for Rajappa’s firm is looking at how to quantify counterparty risk. There’s also talk of a market response in the form of a clearinghouse, which would operate like a futures exchange and where the margin requirements would be clear and enforced.

“The current turmoil has changed the balance between OTC instruments and exchange-traded instruments in favour of exchange-traded,” says Garry Jones, executive director at Liffe-NYSE Euronext. “Because CDSs were traded OTC there was no exchange discipline and the problems took a long time to come out.”

Liffe-NYSE Euronext already has a proven service called Bclear whereby trades can be pre-negotiated OTC then given up to
the market for trade administration and clearing. It’s already available for equity derivatives and is about to be expanded to cover credit derivatives too.

Need to know basis
Mind you, even the most thorough assessment of counterparty risk can only take you so far. It won’t help you if your own operation is contaminated.

“The industry has focused a huge amount of time on ‘know your client’ activities,” observes Geoff Harries, vice president, product strategy, CheckFree, a financial technology provider. “Perhaps the same diligence will now need to be applied to ‘know your counterparty’ and ‘know yourself’, in terms of managing risk exposure both external and internal across counterparties.”

Soon knowing your counterparty and yourself will probably be obligatory anyway. Transparency and clear audit trails are sure to be a focus for the regulators when they come to mop up after the dust from the current crisis has settled.

“The experience we’ve just gone through does not make regulation look like a necessary evil, rather a necessary good and a small price to pay for the markets to operate and avoid financial crisis,” says Harries. “Markets which are over-the- counter can still operate under regulated conditions, but exposures need to be managed in line with the ability of the people who underwrite the exposure to deliver or for early warning systems to prevent financial meltdown.”

Perhaps the biggest lesson to come out of the past year in derivatives, however, is the very simple one that it’s important to understand completely what you’re doing. For investors, suggests Park, a good rule of thumb would be: if you don’t understand it, don’t buy it. He also suggests that some of our current difficulties spring from the fact that neither regulators nor governments understood everything that was going on in our highly complex financial markets.

“The regulators have trouble attracting talent,” says Park. “It’s difficult for them to find minds as sharp as your average hedge fund analyst or investment banker, so the regulators did not know what was going on. They didn’t know what they didn’t know or they would have dug into it.”

More regulation
They know now, and Park predicts tougher regulation aimed at banks and hedge fund counterparties. “The Lehman failure has damaged the existing prime broker business model,” he says. “There will be more regulation of prime brokers and ultimately a new model somewhere between the existing prime broker model and a custodian.”

The outcome could be positive, he suggests, but there are dangers too. There’s a lot of anger out there from the man on the street, corporate treasures of ordinary businesses, and from politicians, and it’s coming the finance industry’s way.

“Politicians like people to think that they are in control and this crisis revealed the brutal fact that they are not in control,” Park says. “They will want if not to exact punishment, at least to make sure this doesn’t happen again.”

It’s therefore very important that everyone pays attention to the dialogue that will shortly start, he says.

It’s also important that the industry plays its part by being clear and open in its communication. Is that happening? Well, I recently received a press release from Actuarials Holding LLC, parent company of Everest OTC Trade Facility and the AE Clearinghouse, about a revolutionary ‘safe’ derivative that opens new profit opportunities with immunity against excess market volatility.

It ran like this: “The Clipper is a ‘standard manufacture’ derivative that structurally caps a gain or loss from an underlying asset to a ‘clip limit’ amount. Whether the trader initiates the short or long side, the trade is automatically filled in a dark-pool exchange. A range of intraday – at every quarter-hour and hour – overnight, weekly, and monthly expirations make Clippers appropriate for almost every
trading style or strategy. The Clipper is a ‘capital multiplier’ unlike any other instrument...”

OK, I’m losing the will to live and looking longingly at our sharper kitchen knives, so I’ll stop there. But in the spirit of the new openness that may lead us out of this nightmare, I’d like to fess up and say I don’t understand a word of that.   ©2008 Funds Europe

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