If you asked the average person what a derivative is, most of them have no idea. Some might tell you they are connected to the financial crisis.
If you ask what caused the financial crisis with the banks, they might tell you the banks leant too much money, which is not entirely untrue. Derivatives are an essential part of the modern financial system. They are also the major cause of the global financial crisis. So what is a derivative, how did they arise, and how can our markets transform to use them as a force for good rather than one of destruction?
A derivative is a financial instrument whose price movement is based on something more basic, called an underlying. This underlying can be a commodity, like oil, or wheat. It can be based on an index or a price basis, like the weather or the result of a sporting match. It is usually in the form of a future, an option or a swap. The earliest form of derivative was in rice, in the 18th century. It was a future that traded on the Dojima Rice Exchange in Osaka, and was a forerunner to the modern banking system. So derivatives, in the form of rice futures actually pre-date the modern banking system, yet derivatives in the last 20 years have broken the global banking system. What has changed?
In the 1990s financial markets were deregulated in response to technological innovation. The logic being with the leap in financial markets technology regulation could be eased as more complex financial models would evolve. These complex financial models were supposed to make financial markets less volatile and therefore more stable and safer. Coupled with this, we had the end of the Cold War, with mathematicians and physicists moving from defense to banking, applying their considerable abilities on developing financial market models instead of military technology. Some people might argue that the Cold War never ended, it just went from military warfare to economic warfare.
The area in which most of this Cold War brain power was deployed was in derivatives swaps, futures and options. There are two markets for derivatives: exchange-traded or OTC (over the counter). OTC contracts are directly between the two parties involved, usually a bank and a customer or bank to bank. Due to their complexity, they became almost impossible to understand, let alone regulate. However, in the late 1990s, the head of the U.S. Commodities Futures Trading Commission (CFTC) Brooksley Born attempted to lobby congress to allow the CFTC to regulate the OTC derivatives market. She was roundly blocked by other regulators, namely the Treasury secretary, the chairman of the Federal Reserve and the chairman of the Securities and Exchange Commission (SEC). They all strongly believed that financial markets needed less regulation, not more.
The first cracks appeared in the derivatives markets in 1999 when a hedge fund, Long Term Capital Management, went bust on the back of the Russian financial crisis. The complex mathematical models used to generate returns by LTCM threatened to cause a systemic crisis on financial markets word wide, as LTCM traded with all of Wall Street’s Major investment banks, and they were all exposed to the losses of LTCM via OTC derivatives. In the end, the Federal Reserve supervised a bailout of LTCM by the banks, making funds available to the banks to lend to LTCM for them to exit their trades in an orderly fashion. Still, regulation by Congress was deemed unnecessary.
Over the last 10 years the OTC derivatives markets have exploded in size, with estimates putting it at $600 trillion notional value. OTC markets remain largely unregulated, despite the taxpayer-funded bailout of the banking system in 2008. Europe is on the verge of a systemic collapse now, and will need structural reform. There is a financial tsunami heading for Europe similar to the one on Wall Street in 2008, and so far regulators and banks are trying to decide which swimming costume to put on, rather than preventing these tsunamis.
Derivatives price movements are based on an underlying. Perhaps in order to better regulate and understand the derivatives market, we first need to overhaul the underlying markets, namely commodity markets, in oil, gas, metals, gold and other physically deliverable trade. These markets have traditionally been opaque, and the traders who dominate them have also been secretive, none bigger than Glencore, the world’s largest commodities trader. Glencore recently went public, and it follows that the physical markets that it dominates should also go public.
Derivatives are useful financial market tools, only if the markets from which they derive their price are transparent, accessible, regulated and of a global standard. It follows therefore, that it is the underlying markets in physical trade that we first need to reform, regulate and account for in order for derivatives markets to be effectively regulated.
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Global Markets are anything but integrated. What if we had a paradigm shift in the way we think, the way we actually do business with each other, between nations. Balanced global trade can only occur if we have transparent, accessible, efficient markets, with standardized contracts and on a standardized platform of global exchange. We are on the cusp of achieving this, although most people cannot see it. Sam’s Exchange aims to give its readers a clearer view and a platform for discussion. Markets, trade and economics are in fact nothing more than the result of our thoughts and actions expressed in numbers, not the reverse.
Sam Barden is CEO of SBI Markets General Trading LLC, a Dubai-registered trading and advisory company. Barden, 39, has worked in the global financial markets for more than 17 years in Europe, Russia and the Middle East. He has advised and executed strategic transactions for both the government and private sector, in particular in energy and commodity markets, advising various energy producing nations on their strategic market developments and interaction. He holds a degree in economics and finance from Victoria University, Melbourne, Australia.
