Derivatives - Good, Bad, and Ugly

The press loves to talk about 'derivatives' as if all the evils of the world can be wrapped up in a single word.  What's wrong with Wall Street? Derivatives.  Why did you lose your job? Derivatives.  Why can't the Mets bullpen get the job done?  Okay, that one's not about derivatives.  I don't think.



Anyway, derivatives do an awful lot of good in the financial world.  A 'derivative,' by the way, is any type of financial security that derives its value from some underlying security or index.  So S&P500 futures are derivatives, because their value is based on the combined value of 500 stocks in the index.  All futures contracts are derivatives - and in fact futures are some of the best and safest derivatives around, which I'll get to in a bit.  Derivatives are generally used to transform one kind of risk into another, so for example a farmer might sell a futures contract obligating him to deliver a certain amount of wheat of a certain quality in October.  The farmer has eliminated his price risk, but now he has to make sure that his crop doesn't fail, because somebody else is expecting that wheat.  Derivatives can be used to swap interest rate risk for equity (stock market) risk, or to reduce or increase exposure to the price of a share or index rising or falling.  The most common derivative there is, the interest rate swap, just converts floating rate risk into fixed rate risk and vice versa.  Because they can be tailor-made to a specific need, and can be created in any amount, they are wonderful tools for taking on and laying off all kinds of risks.

On the other hand, this is exactly why they can be bad.  Unlike futures, which are tightly controlled by futures exchanges, most derivatives are traded 'over the counter,' as an individual contract between two parties.  This means that there is no central pricing authority that sets a valuation for these things - again unlike futures, which have clearly known and published prices throughout the day, as well as official opening and closing prices.  Futures exchanges also closely regulate the size of positions, and have very strict margin requirements, including daily settlements of profits and losses.  In over the counter derivatives, counterparties rely on individual agreements about margining, and firms make their own assessments about the creditworthiness of their trading partners.  In practice this means that large derivatives positions can be built up without putting up large amounts of money (leverage, anyone?), and counterparty risk can be very significant over time.

Even worse - and uglier - is that many derivatives can be very hard to value, because they may be based on underlying securities that are themselves hard to price, or hardly ever trade.  Firms have to rely on their own modelers to tell them what things are worth, and they sometimes get it very, very wrong.  Furthermore, banks and brokerages have been woefully negligent in keeping up with the paperwork, and may not have a full understanding of the market risk in their derivative positions, let alone the counterparty risk.  This is why a firm like, cough cough, Bear Stears could not be allowed to go bankrupt in a disorderly way.  Tens of thousands of derivative contracts, many of them almost impossible to value, would have to have been unwound in a matter of days, and that could have locked up the entire financial system.

It's not the concept of derivatives themselves that is the problem - its the sloppy way they've been used.  In a very real sense, derivatives perform many of the risk and credit transfer functions that - theoretically - are the domain of banks.  The problem is, you don't have to be a bank to use derivatives, and even banks don't account for them the same way they do for things like loans and investments.  In effect, large chunks of the banking system have been taken 'off the balance sheet,' where the normal rules of regulation and - dare I say it? - prudence just don't apply.  And THAT's why derivatives might one day come to your door in the middle of the night and suck your soul out through your eyeballs.  Don't say I didn't warn you.