Since the recent amendment to the SEC Act, and establishment of a Derivative Exchange and a Central Clearance house, derivatives have become legally recognized financial products in Sri Lanka. This article is an attempt to draw caution and an appeal to ‘tread carefully’ in a highly controversial derivative ‘mine-fields’.

Many, mistakenly comprehend that the recent Sub-Prime mortgage crisis in America as the main reason for the near banking collapse experienced by the west. Although partially true, the real ‘malefactor’ behind the disastrous melt-down was a derivative product called CDS – Credit Default Swaps. Aided by asset-backed securities and Collateralised Debt Obligations – mockingly known as Chernobyl death obligations - ‘swaps’ brought insurance giant AIG to its knees and the banks and the financial system to the edge of collapse.

Intrigued by the global financial crisis, even inquisitive ordinary people have taken an interest in the extraordinary and arcane world of derivative products. Derivatives, a gigantic system of commercial bets in financial markets the world-over where the total outstanding amount stands at an staggering $600 trillion (some 10 times the value of Global Production) has, albeit controversial, become an intricate and permanent part of financial markets. Since derivatives are virtually unknown in Sri Lanka let me briefly introduce you to the basics.

What are Derivatives: They are financial products such as Options or Futures derived from other underlying investments such as Shares, Share Indexes, Commodities and Currencies etc. Still confused? Simply, it is any agreement or a contract that is not based on a real or true exchange, ie: there is nothing tangible like money or a product that is being exchanged. For example if you step into a Book- store pay cash and buy a book the exchange is instant and both parties have something tangible,(you the book and the shopkeeper the cash).

But if you ring the bookstore and ask him to retain the book till tomorrow and he agrees, then a derivative has been created. Derivatives are agreements between two people or two parties – that has a value determined by the price of something else (called the underlying). It is a financial contract with a value linked to the expected future price movement of the asset it is linked to – such as a share or a currency or a commodity. Most popular, interest-rate derivatives and credit derivatives are other varieties. Derivatives can also be use to acquire risk, rather than to insure or hedge against risk. Derivatives are categorized as follows:

Options : The right to buy or sell a share or a financial product at a stipulated price within a certain period. For example, Hedging falls under ‘Options’.

Futures : Contracts to buy and sell commodities and financial derivatives at specific prices at future times.

Swaps : A contract between a party with a fixed rate security and a party with a variable rate security to exchange future interest rate payments. ( A form of interest rate Insurance). These are contracts to exchange cash (flows) on or before a specified future date based on the underlying value of currencies, Exchange rates, Bonds, Interest rates, Commodities, Stocks or other Assets.

Derivatives are used by Investors to:

• Speculate and make a profit if the value of the underlying asset moves the way they expect
• Provide leverage or gearing, so that a small movement in the ‘underlying’ can cause a large difference in the value of the derivative.
• Hedge or mitigate risk.
• Obtain exposure to ‘underlying’ where it is not possible to trade in the underlying (e.g., Weather derivatives)
• Create Optionability where the value of the derivative is linked to a specific condition or event.

Derivatives are traded in an organised Exchange or Over the Counter (OTC). The derivatives that go-through an exchange - Futures and options- are transparent and proper where performance is guaranteed, while the Over the Counter derivatives like the dreaded ‘Swaps’ which are normally tailor-made to suit different parties, and comprise the largest market, are not scrutinised or guaranteed, although they fall within the purview of the International Swaps and Derivatives Association (ISDA) which is currently facing a torrent of criticism - aftermath of Credit default swaps disaster ‘Fallouts’-
According to western observers, modern day derivatives suffer from ‘split personalities’ not dissimilar to that of Dr.Jekyll and Mr Hyde.

Derivatives do perform important risk-transfer functions within modern capital markets – that is its Dr. Jekyll side. Then there is the evil Mr Hyde side, where derivatives are used to speculate, keep dealings off balance sheets and out of sight (create Rouge Dealers like Nick Leeson – who brought Barings bank to bankruptcy), increase leverage, arbitrage regulatory and tax-rules, and manufacture exotic risk cocktails.

The world witnessed recently, how via corporate malfeasance, evil overwhelmed the derivative markets in the west. For companies, the ability to use derivative trading to supplement traditional earnings, which are under increased pressure, is irresistible. The complexity of modern derivatives has little to do with risk transfer and everything to do with profit maximisation. Politicians, Market Gurus and western media have labelled derivatives as ‘Weapons of mass destruction’ which are responsible for massive corporate losses and the downfall of companies such as AIG and Lehman Brothers. Orange County in California which went bust is also another victim of misuse of derivatives.

Although, Sri Lanka’s foray into derivatives, is still in its infancy, it can derive great benefits from the above disastrous experiences of our western forerunners. In reality, Derivatives instead of being a be’te noire, if properly used could be a force for financial strength and stability. Derivatives which facilitate buying and selling of risks are an integral part of any modern vibrant capital market.

To a country rising from a deadly war, and harbouring aspirations to be a regional power, a strong financial market is essential and derivatives is certainly the paradigm shift that is needed to make it possible.

Precautions: It is imperative that we take precautions and manage diligently, make sure that all derivatives go through the Exchange and are properly monitored. It is also important that deals and contracts should be less sophisticated and less exotic plain Vanilla versions, and perpetually transparent. Adhering to market-ethics and proper checks and balances with adequate liquidity will safeguard and bring confidence and stature to our primitive derivatives market along with foreign participants.

* The writer is based in London