Preface
Derivatives aren’t dangerous, only the people who use them with-
out understanding their characteristics and how to clear, settle
and manage the operational risk.
The world of derivatives is sometimes viewed as a highly technical and
somewhat mystical area of the financial markets. It also has, in some
quarters anyway, a poor reputation following various high-profile
situations involving rogue dealing and large losses on transactions.
The reality is that derivatives are a product that is primarily designed
to transfer risk and without the use of derivatives in commerce,
commodities, investment and finance, there would be extensive
fluctuations in supply and prices plus increased uncertainty.
The derivatives industry is therefore fundamental to the economic
well-being of such diverse entities as governments and farmers,
global corporate entities and fund managers, bankers and manufac-
turers, and the individual as well, not that the latter may always be
aware of their affinity with derivatives. Derivatives are fundamental
to the well-being because they allow risk to be avoided, reduced or
increased, thereby offering both protection and opportunity.
Everyday life is influenced by supply and demand, prices, disaster,
wealth and numerous other factors. Risk is always there but not
always evident. Few investors will be aware, for instance, that a fund
manager that hedges against a fall in the stock market through the
use of derivatives has in fact protected, to some degree anyway, their
investments. The shopper in the supermarket is probably unaware
that the price of the jar of coffee they buy is affected by how effective
the producer was in ‘locking in’ the price of coffee beans some time in
the past.
Both the investor and the shopper may, however, be aware of a
young man who broke the bank, literally through his uncontrolled
and seemingly unnoticed activities in derivatives in Singapore. Both
x Preface
the shopper and investor would be unlikely to risk not insuring their
house or car and yet mention the use of derivatives, and the chances
are they would be either confused or fearful or indeed both!
Such is the ignorance of derivatives in many quarters that in the
wake of the Nick Leeson debacle there were calls, many from leading
politicians and the so-called experts to make them illegal. How little
these politicians and ‘experts’ understand the real world.
Derivatives did not cause the collapse of Barings Bank, but
abysmal management and inadequate controls did. Call for a ban on
derivatives use and in effect you are calling for a ban on insurance
policies.
Thankfully in spite of, or maybe because of, episodes like Leeson
there is today a greater understanding of derivatives, how they work
and what they do, but it is still the case that to many within and
without the financial services industry they are shrouded in mystery.
Many peoples’ first real awareness of derivatives then was when
Nick Leeson famously destroyed a 200-year-old UK Bank. Perhaps
more surprising was the fact that many of those people worked in the
financial markets. In the aftermath of the collapse of Barings in
1995, many wild and somewhat ludicrous assertions were made
about derivatives by the so-called experts who had suddenly materi-
alised. They collectively blamed derivatives for nearly every problem
in the world, bandied around words and phrases like ‘catastrophe’,
‘disaster’, ‘ highly dangerous products’, ‘total gambles’, etc. No doubt
this sensationalism made good news stories in the media but just
like so much news it was just media hype.
The bank went bust because of poor management and non-existent
and ineffective controls, as simple as that. Derivatives were simply
the products Leeson traded. It might have been fair to say that the
characteristics of the product made it possible for the loss to accu-
mulate in a relatively short time, but other than that derivatives were
incidental and not the cause of the problem.
Another misconception bandied around was that these were ‘new’
products. But they were not; in fact they are products whose origin
can be traced back to the days before cash when ‘trades’ were an
exchange of goods or what today we might call a commodity swap.
Much later, in the 1800s a more formalised style of trading in com-
modities saw the creation of futures contracts that could be traded
on an organised exchange, the Chicago Board of Trade, which was
established in 1848 for the trading of contracts on grains.
The creation of these standardised contracts and an organised
market enabled farmers and merchants to hedge against risk by
locking in the price they would receive or pay in advance of the
actual time of delivery of the commodity. The system worked well cre-
ating certainty where, before that, there was no way of knowing what
the price would be until harvest time. Speculators took the risk that
hedgers wanted to get rid of. They were hoping to profit from a rise in
price or to be able to trade their positions benefiting from price
changes. Not surprisingly the volume of trading in these contracts
increased, as more and more people recognised the benefits of using
futures.
However, it was not until the 1970s that users of the financial
markets needing to manage risk being generated by fluctuating inter-
est rates and currency exchange rates turned to futures contracts to
enable them to hedge against the risk.
The impact was quite dramatic. The number and variety of financial-
based futures contracts that were introduced not only on markets in
Chicago but also elsewhere in the world increased massively, so too
did the use of another derivative, option contracts, so that by the late
1980s the global volume of traded contracts had grown from under
10 million annually to over 800 million. The popularity and spectacu-
lar growth in the use of exchange-traded products overshadowed
the over-the-counter (OTC) or negotiated market for derivatives. This
market was also popular as trades were made in products that were
not available on exchanges and also when a more bespoke product
was needed rather than a standardised one. However, there were
issues like counterparty risk and the need for documentation every
time a trade was entered into. Later these would, to a large extent, be
resolved, and so a massive exchange-traded and OTC derivative
market came about.
The increase in the use of derivatives is easily explained.
As the world became a global market place and as the residual
impact of the Second World War faded, the risk in terms of fluctuat-
ing prices, interest rates and foreign exchange rates increased enor-
mously. Once again there was uncertainty and the need to be able to
hedge against that uncertainty became important. Futures and
options and various OTC products met that demand and so in com-
merce, banking and investment, expansion took place and volumes
in derivatives increased, which created liquidity, encouraged expan-
sion, etc.
When Barings happened, although there was much negative com-
ment very little was heard about how for years derivatives had been
used successfully by numerous organisations. Few thought about
how everything from the price of coffee to the interest rate on their
Preface xi
fixed-rate mortgage was in no small way directly or indirectly affected
by the derivatives markets.
Just like with any product or market, there will be times when
someone probably has a bad experience using derivatives. This
needs, however, to be looked at in the context of the size of the mar-
ket. Losses attributable to errors, strategy or operational, and prob-
lems with using derivatives is a tiny figure compared to the value of
all the derivatives traded. This may be of no comfort to those who
suffer such an experience but it is important when hype and sensa-
tionalism so often seems to be aimed at the derivatives industry.
Today, contracts of several billions are traded; over-the-counter
activity of many trillions of dollars, in value terms, occurs; and the
growth continues.
Naturally market, credit and operational risk are features of using
derivatives. Effective processing and controls on derivatives business
are therefore critically important. Exchange-traded derivatives, and
some OTC derivatives benefit from the fact that they are traded in a
significantly regulated environment and are cleared and settled by a
clearing house that is not only efficient at administering transaction
processing but also an expert at managing risk.
The member firms of these clearing houses, usually banks and
brokers, need to meet strict criteria to have such status. This is a
comfort for the customers who deal with them, as the bank/broker is
effectively their ‘clearing house’ and is often referred to as the ‘clear-
ing broker’. Counterparty risk is an issue with the off-exchange
transactions but here highly effective documentation offers both par-
ties to such a trade a legal comfort that the terms will be honoured.
The bottom line is that today derivatives use is taking place in a
mature and highly professional environment with regulation, sophis-
ticated systems and by and large competently managed organisa-
tions. New entrants to the derivatives markets are able to benefit
from the experience of the mature participants and also from an
extensive range of education and training products.
Much of the comfort factor in using derivatives stems from being
sure that controls over the activity are strong and that the adminis-
tration of the transactions is efficient. The role of the derivatives
operations team is therefore a significant one being both a protector
of profit and also a major contributor to controlling the risk.
In this book and the accompanying CD-ROM the reader will see
what the various roles and functions are, who the participants are
and how different products require different processes, procedures
and controls. If nothing else it should dispel the myths that existed
xii Preface
after Barings and still exist to some extent today. The book will help
to explain why derivatives came about, how they get used and the
settlement and other issues that occur when derivatives are used.
Anyone not familiar with these products is, we think, going to be
pleasantly surprised as they read through the book. The myths will
be removed and we hope the interest stimulated.
Derivatives aren’t dangerous, only the people who use them without
understanding their characteristics and how to clear, settle and
manage the operational risk.
David Loader
April 2005
Preface xiii
..................Content has been hidden....................
You can't read the all page of ebook, please click here login for view all page.