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Defined, Described and Distinguished
By Leo Melamed
March 13, 2008
in the financial world is talking about derivatives. Precious few
know what they are talking about. 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, CDO's 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
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.
It enabled mankind to peer into the fundamental components of nature
and manipulate them. I have often stated, computer technology moved
mankind from the big to the little, from macro to micro --- from
looking at the universe in its entirety to discovering the smallest
forms of matter. Just as technology enabled mankind to discover
subatomic particles in physical science, just as technology enabled
us to discover the genetic code in biological science, so technology
enabled us to manipulate components of risk in financial science.
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 investors' preferences. We entered the era of particle finance
which impacted every aspect of markets and investments.
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.
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." ]
today are applied within two separate regimes: Over-The-Counter
(OTC) derivatives, traded privately among banks and their large
corporate and institutional customers; and Exchange-traded derivatives,
financial and commodity futures and options. Combined, these two
sectors represent a multi-trillion-dollar market.
the derivative markets, both OTC and exchange traded, provide risk
management capabilities on a vast array of products from finance
to energy, from securities to the environment, from banking to agriculture.
Derivatives 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.
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% per year.1 OTC
global growth over the past 10 years went from $150 trillion in
1997 to about $950 trillion in 2007.
global exchange-traded derivatives 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 thousand in 2000
to 11 million in 2007. CME Equities products grew from 258 thousand
contracts in 2000 to over 2 million in 2007. CME Interest Rate products
grew from 560 thousand in 2000 to 3.6 million in 2007. CME FX global
products grew from 76 thousand in 2000 to 555 thousand in 2007.
This phenomenal story speaks for itself.
is estimated that over 90% of the world's 500 largest companies
use derivatives on exchanges and OTC to help manage their business
exposure. With prudent risk controls in place, for the vast majority
of financial managers these risk management tools 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.2 However, these complex
and sophisticated financial tools require expert comprehension.
Used improperly, they can create unacceptable risk.
striking difference between the OTC market and futures exchanges
traded on exchanges are generally standardized bench-mark products
like currencies, interest rates and equities. They provide risk
management to an entire asset class --- call it the big.
the other hand, the OTC market has created an array of derivatives
products that are narrow-based, non-standard, and often tailored
to the needs of a specific customer or group of customers ---
call it the little.
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.
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, e.g. 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.
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 not simply dependent 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.
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 SIVs debt off its
balance sheet while receiving a management fee from the SIV. The
SIV industry grew to become a $400 billion industry.3
purpose here today is to define, describe and distinguish derivatives.
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 with 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, lack
of proper risk management controls.
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. They borrowed money short-term
and invested it long-term without regard to credit considerations.
It was a recipe for disaster. The 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.
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, and
high energy and food prices, coupled with a continued drop in U.S.
currency values accelerated an inflationary effect. The consequential
result has brought the U.S. unto the brink of a recession.
the depth of the problem has been recognized. Regulators from France,
Germany, Switzerland, the UK and the US 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."
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.
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 and exchange
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.
markets generally lack the regulatory control of federal authorities
to which futures and options exchanges are subject.
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.
OTC derivatives may take place on multilateral trading platforms,
clearing and settlement is by its very nature bi-lateral --- this
means OTC derivatives are not assets that can be traded freely.
with different counterparties are usually not fungible which makes
it difficult for traders to close positions. Contracts often have
long maturities, and counterparty risk a much greater concern
in OTC derivatives markets than in securities markets.
OTC derivatives contracts may themselves be very complex, involving
payments that depend on prices of other assets.4
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 ten years
into the future --- there exists a real price established every
day in a notoriously open forum-now primarily Globex. In futures
no artificial pricing can occur. There is no "mark to modeling." To
be specific, the exchange clearinghouse system of multilateral clearing
and settlement provides:
Counterparty Clearing (CCP), with a central guarantee to every
transaction --- eliminating counterparty credit risk;
of valuation with twice daily (at the CME) mark-to-market disciplines
--- eliminating accumulation of debt;
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.
payment of settlement variation and margining --- making it difficult
for traders to hide losses or disguise unusual profits.
oversight and financial surveillance procedures --- the antithesis
to the largely unregulated OTC market
Buffet, 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.
of Yale, 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.
conclusion, I want to leave you with this thought:
derivatives nor the markets are to be blamed for the problems the
world faces today. The markets as well as derivatives are tools
--- mechanisms that perform an important function without which
the world cannot advance or prosper. The tools are innocent. They
are applied by human beings. Don't blame the tools for the actions
Quarterly Review, December 2007.
2Remarks by Chairman Alan Greenspan, before the Futures
Industry Association, Boca Raton, Florida, March 19, 1999.
3 In 1988-89, two bankers at Citigroup launched
the first two such structures called Alpha Finance Corp.
and Beta Finance Corp. In 1993, the bankers formed Gordian
Knot to become the world's largest SIV with some $57 billion
4BIS Quarterly Review, December 2007.