Derivative contracts don't have to be disasters
March 11, 2004
Financial derivatives in the mid- to late 1990s were generally known for one thing: disasters.
Whether it was the Orange County debacle in California, the Proctor & Gamble fiasco, or indeed the most celebrated event of them all - Nick Leeson's blow-up of Barings - derivatives were synonymous with financial disasters, and on an enormous scale.
We even had our own South African episodes at Real Africa Durolink and WJ Morgan.
However, in all of these cases the underlying cause of the disaster was not the derivative contracts per se, but the inappropriate use and management of them
'Understood and applied properly, they can reduce risk and provide efficiency' |
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Derivative contracts by themselves are not dangerous. It is the use of the derivative contracts that can become problematic.
In the case of Barings, the disaster was a result of appalling management and a complete lack of control when it came to the administration of the derivative positions.
With Orange County, the crisis occurred as a result of a spectacularly disastrous bet on the direction of interest rates.
Derivatives were employed to facilitate this bet but did not cause it to be placed in the first place.
With Real Africa Durolink, once again, very poor controls and procedures led to the loss.
In all these events it was not the derivative contracts that resulted in the losses but the speculative positions, or bets, that were chosen in the first place - or the poor controls that were in place with the administration of the derivatives.
The term "derivative" refers to a very broad spectrum of financial products.
It is partly as a result of this lack of standardisation of derivatives that we have seen some of the disasters that have occurred.
Simply put, there is no standard derivative. each of them has its own peculiarities, differences and nuances.
As a result of this lack of standardisation or commonality, when derivatives first came into the mainstream there was little understanding about them and hence no formal approach to dealing with the associated risks.
Things got out of control.
We have progressed dramatically since then. The management of derivatives, both in terms of the risks they generate and the control processes surrounding their administration, has improved substantially.
Financial professionals, managers and clients now fully understand and use them appropriately. As a result, derivatives, employed correctly, can be used to substantially reduce risk and create user-friendly, efficient products.
Probably the best example of this is the proliferation of the fixed-rate mortgage, or indeed mortgages with caps, which we see in most European economies.
These relatively common products are created through the extensive use of financial derivatives and reduce mortgage holders' risks considerably.
Furthermore, derivative contracts such as futures or contracts for difference (CFD), which expose traders to the change in the value of an asset without having to own the underlying asset itself, are far more efficient than traditional financial products such as equities, with the efficiency gains passed on to the end user.
An equity CFD mirrors exactly what an equity does, but the cost of trading an equity CFD is 0.35 percent, while trading most equities in South Africa costs about 1 percent.
Furthermore, CFDs avoid the 0.25 percent marketable securities tax that equity trading incurs.
So, in summary, derivatives should no longer be a dirty word. Once understood and employed properly, they provide tremendous efficiency and can reduce risks substantially, which ultimately benefits the consumer.
Derivatives should be embraced - but first understood.
David Butler is the executive chairman of Global Trader 247
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