Derivatives are all the rage these days. Presently, the US Senate is debating a Bill that would establish a better regulatory framework for derivatives.
Meanwhile, the eurozone is struggling with the effects of skyrocketing derivatives for the sovereign debt of Greece and other members of the EU. A new derivatives market has just opened in China and both the trading and prices have been rising at a spectacular rate. Not to be outdone, the International Islamic Financial Market (IIFM), a Bahrain-based Islamic capital markets body, and the International Swaps and Derivatives Association (ISDA) have come up with standardised documentation for derivatives instruments that comply with Sharia, or Islamic law.
In theory, derivatives are supposed to hedge risks in developed markets. Often, they have the reverse effect and they can create a disaster far larger than the problem that they were supposed to cure. There are several reasons.
The first has to do with counter-parties. Derivatives on their simplest level are nothing more than contracts. A contract is simply an agreement between two parties to do something in the future. In the case of a derivative, that often requires the payment of money by one party to another upon the occurrence of a specific event—usually a loss or a default.
When the triggering event occurs, the party who experienced the loss asks the other party to the contract, the counter-party, to pay up. But what happens if they don’t? What happens if they can’t or won’t? In the United States, this is exactly what happened. Many of the big Wall Street banks like Goldman had AIG as a counter-party. When the collapse occurred it became clear that AIG couldn’t fulfil its side of the bargain. As a counter-party, it was a failure and the derivatives contract would have been worthless, except that the US government stepped in and guaranteed the deal.
This is still an especially difficult problem or for the eurozone and Islamic finance, because of the extra layer of cross-border guarantees and enforcement. The issue is having dramatic consequences in the EU, where European banks are so worried about counter-party risk that interbank lending is limited to overnight and spreads over three-month rates have soared. All of this is due to counter-party risk across borders.
The next question is how is the contract to be enforced? It may be possible to enforce these contracts in the US and EU. Emerging markets are a totally different story. The Chinese financial system is replete with massive toxic assets, because it is basically impossible to collect a debt. Any problems with their new derivatives markets will most likely not be resolved. Other emerging markets are hardly better.
The cross-border issue is also a problem for regulators. Which regulators are responsible for policing these transactions? We also have to assume that there are regulators, that they have jurisdiction and that they both will and can enforce the regulations on their respective country’s books. Legal disincentives without enforcement by regulators or courts are worthless. So would be the value of derivatives as insurance.
The real problem with counter-parties often is asymmetry of information. The contract or derivative—whether standardised or not—is a private transaction. These derivatives are not yet traded on any exchange. One of the main causes of the 2008 financial collapse and the present strains in Europe is the lack of information. No one knows the extent of the interconnections, so without information markets can collapse. Derivatives increase the interconnections and decrease the information. One of the main aspects of the new US reform would be to require derivatives to be traded through a clearing house. This would provide both transparency and the potential to both provide and monitor collateral.
The end result may not be hedging risk, but creating more. The illusion that a specific investment is protected from loss may result in investors taking risks that they would not otherwise have taken. If they feel protected by the derivatives contract, there is less of an incentive to do more due diligence. This was proved recently when the holders of unrated illiquid “asset-based” sukuks (Islamic bonds) realised that their investments were in fact not collateralised.
No doubt derivatives if properly regulated might actually do some good, but we have to wonder why they are so important. After all, this market is quite new both in terms of the scope and size. Markets did pretty well for most of their history without these new instruments. The answer came at the end Financial Times article about sukuk derivates. According to a banker at a Western bank, “In theory, the potential market size is several billion dollars per annum of structured investment products and hedging instruments, but we’re barely scratching the surface today.” So the real reason has nothing to do with risk management, but a lot to do with profit management for Western investment banks.
(The writer, William Gamble, is president of Emerging Market Strategies and can be contacted at [email protected] or [email protected]).
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