Derivatives, Defined, Described and Distinguished
By Leo Melamed

Peking University
Beijing, China
March 13, 2008

Derivatives Defined

Everyone in the financial world is talking about derivatives. Precious few understand the subject. In truth, before 1990, one would be hard-pressed to find the word “derivatives” in financial textbooks, nor would you have encountered the acronyms like SWAPS, CDOs, or SIVS and so on. In 2006, you would have to scour the pages of the Wall Street Journal to find even one mention of SIV. Today, it is literally impossible to open the pages of national or international financial publications without encountering those acronyms again and again.

The reason is quite simple. The financial instruments we are talking about are a modern invention, a consequence of computer technology. As we all know computer technology changed the course of civilization. With computer technology, financial engineers learned to divide risks inherent in stocks, bonds, foreign exchange, and commodities into their basic components. In other words, to disaggregate, repackage, and redistribute risks and their corresponding rewards, exchanging one set of risks and rewards for another that responded better to an investor’s preferences. We entered the era of particle finance, which impacted every aspect of markets and investments.

The simplest definition of derivatives is that they are instruments of finance—the value of which is determined by reference to one or more underlying assets or indices. They are used as a management tool to enhance investment returns or protect against inherent business exposures in foreign exchange rates, interest rates, equity values, and commodity prices.

The China Banking Regulatory Commission (CBRC), in promulgating “Interim Rules on Derivative Business of Financial Institutions,” offered a similar definition: a type of financial contract the value of which is determined by reference to one or more underlying assets or indices, including forward, swap, option and other transactions with derivatives features.”[AU: why is this in brackets? Did you add this for this edition?fixed]

Derivatives are applied primarily in over-the-counter (OTC) form and traded privately among banks and their large corporate and institutional customers. Futures contracts are primarily traded on regulated exchanges. Combined, these two sectors represent a multi-trillion-dollar market.

Today, the financial markets, both OTC derivatives and exchange-traded futures, provide risk management capabilities on a vast array of products, from finance to energy, from securities to the environment, from banking to agriculture. These instruments are used by domestic and international banks, public and private pension funds, investment companies, mutual funds, hedge funds, energy providers, asset and liability managers, mortgage companies, swap dealers, and insurance companies.

OTC derivatives markets have been enormously successful and have grown rapidly since the BIS began monitoring them in 1995. Notional amounts outstanding of OTC derivatives of all types increased more than tenfold between 1995 and 2007, a growth rate of over 20 percent per year.

Similarly, global exchange-traded futures grew from $38.6 trillion in 1994 to $400 trillion in 2007. Their growth at the CME, for instance, the world’s largest futures exchange, has been dramatic. Annual CME average daily volume (ADV) has risen from 917,000 in 2000 to 11 million in 2007.

Derivatives Described

With prudent risk controls in place, for the vast majority of financial managers, OTC derivatives have worked exceptionally well. Used properly, they allowed market risks to be adjusted quickly, more precisely, and at lower cost than is possible with any other financial procedure. A process that has improved national productivity, growth, and standards of living. However, these complex and sophisticated financial tools require expert comprehension. Used improperly, they can create unacceptable risk.

One striking difference between the OTC derivatives market and futures exchanges is that futures traded on exchanges are generally standardized products in currencies, interest rates, and equities. They provide risk management to an entire asset class—call it the big. On the other hand, the OTC market has created an array of derivatives products that are narrow-based, nonstandard, and often tailored to the needs of a specific customer or group of customers—call it the little.

Allow me to briefly describe two of the most utilized OTC derivatives, the ones you have been reading about recently: the collateralized debt obligation, CDO, and the structured investment vehicle, SIV.

The CDO

Since their introduction in the late 1980s, CDOs became the fastest-growing sector of the asset-backed synthetic securities market. It begins when an investment bank creates a CDO and provides it with an inventory of asset-backed securities. The collateral assets are restricted to debt—for example, corporate bonds, emerging market bonds, asset-backed securities, mortgage-backed securities, REITs, bank debt, bank loans, and other credit derivatives. Although CDOs vary in structure and underlying collateral, the basic principle is the same.

The CDO entity then slices the assets and liabilities into tranches by reference to credit risk and income. Rating agencies rate the tranches. The CDO now sells the tranches (cash flows coupled with inherent risk) to investors based on their risk objectives. The investors take a position not in the underlying assets but in the CDO entity that defined the risk and reward of the inventory. Consequently investors are dependent not simply on the quality of the inventory but also on the quality of the calculations made by the creators of the CDO model. That is critical to understand: Values are not determined by mark to market but by the calculations in the model. The greater-risk pieces of a CDO pay greater returns to their investors. The investment bank gets management fees for managing the CDO.

The SIV

An SIV is an OTC structured investment vehicle. The concept, initiated in 1988, was very novel. Similar to a CDO, it can be likened to a virtual bank. A bank could create a fund that would borrow money—short term—by issuing commercial paper close to the interest rate of LIBOR. Then it uses the money to lend—long term—by investing in asset-backed securities and mortgage-backed securities (mortgages, credit cards, student loans, and similar products). Liabilities are again sliced into tranches by reference to the credit risk, and then rating agencies would rate the tranches. The tranches are sold to investors based on their risk objectives. The difference between the earnings on the bonds and the interest on the commercial paper represents the profit for the investors of the SIV. Since the bank does not take the credit risk, it can keep the SIV’s debt off its balance sheet while receiving a management fee from the SIV. The SIV industry grew to become a $400 billion industry.³

My purpose here today is to define, describe, and distinguish derivatives and futures. It is decidedly not to assess U.S. or global economic conditions. Still, it is difficult to accomplish my assignment without at least a brief mention of the fact that global economic conditions have deteriorated. Not being an economist, it is not for me to point fingers. Indeed, there is no single culprit; there is plenty of blame to go around. But clearly the root cause can be found first in the fact that during the past decade, the world became awash with liquidity, resulting in a global economic bubble. Easy credit created a pyramid of debt. Second, greed led to a lack of financial discipline. Finally, these conditions led to a breakdown of proper risk management controls[AU: ok, or make this a full sentence? ok].

I suppose much of what went wrong lies in the propensity for human nature to take a good thing too far. It is as true in finance as it is in every form of human endeavor. Cheap credit induced a housing boom, especially in the U.S. It was grounded in the fallacious belief that housing values will go up forever. Risk became excessively underpriced. As home prices and mortgage lending boomed, bankers found ever more clever ways to repackage trillions of dollars in loans, selling them off in slivers to investors around the world. In a rush for better returns, some banks abandoned common sense. They disregarded proper risk controls. It was a recipe for disaster. The OTC CDOs and SIVs had a role in that result, becoming tools for this dangerous application. Randal Forsyth, the financial writer for Barron’s, offered the following analogy: He suggested that just as steroids, a modern medical invention, helped the performance of baseball players, SIVs, a modern financial invention, helped the performance of banks. The use of SIVs was of course not illegal, but the analogy is valid since their purpose was to keep the given risk off the bank’s balance sheets. In doing so the bank’s returns looked much better. Until, that is, the market itself forced the truth to come out.

The problems unfolded when subprime mortgage loans in the U.S. began to have trouble meeting their mortgage obligations. In the summer of 2007, weaknesses in the short-term debt market soon sparked a broader credit crisis. The financial world watched with increasing concern as the commercial paper market—on which SIVs rely for much of their funding—began showing severe strain. The difference between the yields on Treasury bill—safe—investments and corporate commercial paper grew sharply. Soon short-term rates skyrocketed and short-term lenders disappeared. The emergency actions by world central bankers did little to stop a contraction of credit and cascading of defaults. The rest is history: Stock markets throughout the world became pressured, consumer confidence fell, market volatility increased, the U.S. housing market fell into disarray, unemployment rose.

Today, the depth of the problem has been recognized. Regulators from France, Germany, Switzerland, the U.K., and the U.S. issued a joint report, released a few days ago, on March 6, 2008, which stated the obvious: Major banks and securities firms that have suffered huge credit losses failed to understand the inherent risks of the securities they bought. Bank losses, the report stated, were incurred by “concentrated exposure to securitizations of U.S. subprime mortgage-related credit.... In particular, some firms made a strategic decision to retain large exposure to super-senior tranches of collateralized debt obligations that far exceeded the firms’ understanding of the risks inherent in such instruments.”

Derivatives and Futures Distinguished

Why have the problems in the credit markets seemingly not spilled over into the futures exchanges? It is an important question with some very sobering answers.

Consider: In stark contrast to the turmoil of recent events, the CME clearinghouse has operated for more than 100 years without failure. In 2007, the CME Clearing House cleared more than 2.8 billion contracts traded on the CME/CBOT, representing more than a quadrillion dollars in notional value terms. In December 2007, the BIS Quarterly Report explained some of the dramatic differences between the OTC derivatives and exchange traded futures:

• The OTC derivatives market greatly overshadows exchange-traded futures instruments. One reason is that in futures, an offsetting position eliminates the original contracts; not so in the OTC market, where the original contract remains in place increasing the total size of the market.

• OTC markets generally lack the regulatory control of federal authorities to which futures and options exchanges are subject.

• OTC markets do not have the protective components of the futures exchanges, namely: daily mark-to-the-market value adjustments, margin deposits, price and position limits, and most notably the guaranty of a central clearing house.

• While OTC derivatives may take place on multilateral trading platforms, clearing and settlement is by its very nature bilateral—this means OTC derivatives are not assets that can be traded freely.

• Contracts with different counterparties are usually not fungible, which makes it difficult for traders to close positions. Contracts often have long maturities, and counterparty risk is a much greater concern in OTC derivatives markets than in securities markets.

• Finally, OTC derivatives contracts may themselves be very complex, involving payments that depend on prices of other assets.⁴

These differences are dramatic. While no system is perfect and no one can foresee all eventualities, these structures and procedures at regulated futures exchanges represent a time-tested mechanism—the very essence of their default-free success. On regulated exchanges, not only are disclosure and transparency the hallmarks of their transaction and clearing mechanisms, there can be no doubt about the integrity of their daily settlement procedures. Even in the most distant Eurodollar contract at the CME—priced 10 years into the future—there exists a real price established every day in a notoriously open forum—now primarily Globex. To be specific, the exchange futures clearinghouse system of multilateral clearing and settlement provides:

• Central Counterparty Clearing (CCP), with a central guarantee to every transaction— eliminating counterparty credit risk.

• Transparency of valuation with twice-daily (at the CME) mark-to-market disciplines—eliminating accumulation of debt.

• Real-time confirmation from a trusted counterparty directly to the back office and the risk manager—risk management systems know the trade the moment it is done. No confirmation means no trade.

• Daily payment of settlement variation and margining—making it difficult for traders to hide losses or disguise unusual profits.

• Regulatory oversight and financial surveillance procedures—the antithesis to the largely unregulated OTC market.

That is not to say, that OTC derivatives are to be banned or feared. That would be unthinkable. For the vast majority of financial managers, whether OTC or exchange traded, these risk management tools work exceptionally well. It is estimated that over 90% of the world's 500 largest companies—domestic and international banks, public and private pension funds, investment companies, mutual funds, hedge funds, energy providers, asset and liability managers, mortgage companies, swap dealers, and insurance companies—use OTC derivatives to help manage their business exposure. Nor could it be different in today’s complex and interdependent financial world. Indeed, if OTC derivatives application were suddenly not available in business today, they would have to be invented. Without them, it would be like going back to the Stone Age. Still, the lessons learned must be applied. It is imperative that OTC derivatives have a measure of regulation, transparency, and disclosure of attendant risks.

Conclusion

Warren Buffett, the world’s most respected investor, offered the best assessment of the cause of today’s economic problems: He compared money managers who promised double-digit returns to the queen in Alice in Wonderland who proclaimed: “Why, sometimes I’ve believed as many as six impossible things before breakfast.” Just like the queen, he explained, “Just about all Americans came to believe that house prices would forever rise.” That conviction made one’s income and savings unimportant. Lenders offered a seemingly unending funnel of money to borrowers “confident that house appreciation would cure all problems.” Today, we are experiencing the pain of that impossible belief.

Yale University professor Robert J. Shiller summed it up this way: “The failure to recognize the housing bubble is the core reason for the collapsing house of cards we are seeing in financial markets in the US and around the world. If people do not see any risk and only the prospect of outsized investment returns, they will pursue those returns with disregard for the risk.”

In conclusion, I want to leave you with this thought:

Financial instruments on regulated futures markets must be distinguished from OTC derivatives. However, neither OTC derivatives nor the markets themselves are to be blamed for the problems the world faces today. The markets as well as derivatives are tools—mechanisms that perform an important financial function. The tools are innocent. They are applied by human beings. Don’t blame the tools for the actions of fools.

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