Two current stories have come together to put the spotlight onto the murky world of derivatives trading – and what they show should fill the financial markets with foreboding. Dell Computer Corp has just announced that it has unwound its final derivatives position (CI No 2,432), and Cray Research Inc has announced an alliance to […]
Two current stories have come together to put the spotlight onto the murky world of derivatives trading – and what they show should fill the financial markets with foreboding. Dell Computer Corp has just announced that it has unwound its final derivatives position (CI No 2,432), and Cray Research Inc has announced an alliance to provide a system to enable companies to track their derivatives exposure. But just what are derivatives? They are intangible financial instruments that ride on the back of tangible assets or securities. In their simplest form, they are wholly beneficial: companies need futures and options contracts where they can buy something now for delivery in three months’ or six months’ time. Buying a foreign currency for delivery in 90 days when a company knows that it will have to meet an obligation in that currency in three months’ time enables the treasurer to sleep easy and not have to worry about what will happening to the Deutschmark exchange rate against sterling or the dollar in the meantime: he will not be caught out having to spend more in his domestic currency than he expected. The same applies to those legendary pork belly futures so beloved of the Chicago Mercantile Exchange. The facility to buy a commodity now for delivery in the future is vital for the likes of an instant coffee manufacturer.
Frosts in Brazil
He doesn’t want to be at the mercy of late frosts in Brazil, and so he takes out several contracts covering the entire coffee season way ahead of time that give him the right to buy the coffee beans he will need now, for delivery at various dates in the future. They coffee will not even have ripened at the time time the contract is taken out, but he is guaranteed his supply at an acceptable price. If there is a glut of coffee, he shrugs, knowing he could have saved some money by waiting, but if there is a shortage, the foolish virgins will be scurrying about bidding up prices to ridiculous levels: his long experience will tell him that demand for his product will fall at the shelf price implied by the spot price for the beans, and he may decide to make a handsome profit by selling a few of his futures contracts. Those kinds of commodity and currency contracts have been the basis of healthy markets ever since trading began. The dangers of derivatives trading start to appear when the traders at the other end of the deals start trading and swapping those deals so that a parcel of coffee and zinc futures gets traded for a parcel of copper and tea futures, and gets combined with some deals on those pork bellies and gets sold on again. That sort of thing doesn’t happen much in commodities – but it is the very basis of interest rate and currency trades and hedges, and options that confer the right to buy a share or a currency – or an interest rate – at a fixed price in the future. A trader may feel over-exposed to the Japanese yen and want to swap some options to buy yen in December for an option to buy yuan (unlikely!) in November. But these days, simple swaps are too tame, and people trade in swaptions, options to swap contracts at some time in the future.
Those options can equally be on shares or bonds, and may also be tied to a contract to buy a widely-followed share index such as the Standard & Poor’s 500, at a given level in the future. It has reached the point today where derivatives traders have to sell or buy the underlying shares in a complex swaption transaction simply to unwind an onerous position, and the sums of money tied up in such contracts – with aggregate values of contracts many hundreds of times the amount of money with which the players actually entered the market – that shares can frequently plummet or soar simply on the basis of derivatives contracts that need to be unwound, with no bearing on the state of the real economy. The trivial danger comes when company finance officers – or British town hall treasurers, decide to do a bit of freelance gambling with their employers’ money in the derivatives market. The size of the risk is underlined by
the fact that Dell has already taken a $13m hit, and is warning that closing of the remainder of its investment derivatives will result in an after-tax charge of about $6.9m in its second fiscal quarter. The complexity of derivatives, and the extent to which they are quite unsuitable playthings for the average company treasurer is that Cray Research Inc and Xticket Systems Inc have come together to create a system that will enable real-time company-wide analysis of complex trading positions in equity derivatives, including convertible debentures, by combining a Cray supercomputer with Xticket software. They will first make available Xticket’s current analytics software for options and convertible debentures available on the Cray EL94 before going on to develop a new generation of real-time risk-management models and algorithms for equity and fixed-income products previously avoided because of their computational complexity, according to Xticket. The moral of that one is that if he or she needs a Cray supercomputer, even an entry-level one, to keep track of exposure to risk, the derivatives market is no place for the company treasurer to play. The mortal danger is highlighted by the fact that General Electric Co Inc’s figures this year are going to look terrible simply because a currency trader at its Kidder Peabody unit allegedly got a bit carried away and created $350m of phantom contracts to hide losses of $90m – and the deals were sufficiently complicated that nobody could see what he was doing until it was too late. Had that been a company with less financial muscle than General Electric, it might well have been driven into bankruptcy, taking thousands of real jobs with it.
Safe as houses
But nothing mentioned so far does more than scratch the surface of the real danger, which is that sometime within the next decade or so, the world’s entire financial and banking system will collapse into financial meltdown by traders setting off a frenzy of selling of underlying securities to cover positions that have suddenly been made untenable by some unexpected event, until the failure to meet its obligations of one player in the sequence of links sets off a chain reaction of failures until much of the banking system is destroyed, some of the financial world’s most weighty names are bankrupted. The wise said it looked to be held up by sky-hooks, everyone else seemed to believe the Tokyo market could only go up – until it cracked, and now no-one expects to see 38,000 on the Nikkei Dow again any time soon. Sterling couldn’t be driven out of the European Exchange Rate Mechanism against the government’s will – but it happened, at a cost of however many billion you first thought of. The Lloyd’s of London market, insurer of last resort, seemed safe as houses until the asbestos claims started piling up. Private houses seemed safe as houses and a one-way bet until real interest rates took off for the stratosphere in 1989 – and no-one now expects to see house prices reached then any time soon. Regulators worry about the complex derivatives markets because their operation is so opaque, but have no idea how to limit the risk. But given the way that all those other nasty things that couldn’t happen have happened over the past decade, is anyone really prepared to bet against an almighty crash in derivatives?