Business Times

Derivatives – the good , bad and the ugly

By A. I. Marikar

The world and more specifically the US , was warned well in advance of the impending financial crisis as a result of extensive use of derivatives by no less a person than the then head of the Securities Regulatory Authority in the US, Brooksley Born.

The recent global financial meltdown which led to the near crash of several financial institutions worldwide especially in the US and Europe, highlighted the dangers of derivatives as an investment option. Most of the financial institutions that needed massive state bailouts in order to remain solvent at the height of the turbulence, carried substantial portfolios of derivatives which at a time of crisis demonstrated very cruelly that they were mere worthless pieces of paper with really no asset value.

A derivative is not a product that most investors understand clearly. There is little transparency in this business and the product itself is something which even dealers of derivatives do not fully understand so as to be able to explain with clarity the full product dimensions. It is by and large shrouded in mystery and is confined to dealing rooms of vendors of this highly speculative financial product. The hallmark of this market is the mystifying jargon that everyone in the derivative vending business uses when marketing it.

Derivative is something that is derived from another transaction and every derivative per se , therefore is not asset based . Explained in simple English it is an intrinsically empty vehicle that is bought, sold and enlarged with layer upon layer of further derivatives heaped one on top of the other. The whole superstructure lacking the robustness of a tangible asset, is built on nothing but asset emptiness.
The world and more specifically the US , was warned well in advance of the impending financial crisis as a result of extensive use of derivatives by no less a person than the then head of the Securities Regulatory Authority in the US, Brooksley Born.

Ms Born finished a brilliant academic career in law at one of the Ivy League Universities in the US. After several years of legal practice in leading law firms, she was appointed the head of the US Securities Regulatory Authority. It was at this time that derivatives were taking the financial world by storm and very surprisingly it was kept outside the scope of any financial regulator in the US.

Ms Born had serious reservations about derivatives. It had carved out a mega market presence in the US and at that time it was a US $595 trillion business. To put things in perspective, China which has the world’s largest foreign reserves, has a mere $2 trillion as foreign reserves. Ms Born very clearly contended that derivatives with that kind of a market impact had to be brought under her regulatory authority and as a first step researched deeply into the product and its market dynamics.

The more she researched the more it became clear to her sharp mind that derivatives were a creaking time bomb. She found that nobody knew, not even derivative specialists, as to what was going on in the markets. She found that there was little or no transparency in this business; it was like a cult churning out magic portions from a big black box. She contended that this was plain vanilla speculation belonging to the same league as gambling. As a thorough professional Ms Born realized the danger derivatives posed to the US financial markets and to the safety of the trillions of dollars invested in it by millions of investors. She pushed hard to regulate derivatives.

But regulation went against the philosophy of the Allan Greenspan school of financial management, and there was strong opposition from many lobby groups especially the big business raking in profits from selling derivatives. Ms Born did not relent.

She wanted a Congressional hearing to discuss the issue in view of its massive financial ramifications. At the hearing, Greenspan argued for leaving derivatives unregulated. He said the successful growth of US financial markets was possible because of the laissez faire, non interventionist policies of successive US governments. He concluded that if derivatives thrive, then it is best left alone and that the market must determine its ultimate fate.

Ms Born argued strongly for regulation. She argued that the $600 trillion financial behemoth had to be caged. She exposed the total lack of transparency in this business and brought to the notice of those in government that no one really knew what was going on in this highly speculative trade. She warned that if the financial bubble should burst with the $600 trillion in the balance sheet of banks and financial institutions, most US big business would be brought to its knees.

The US administration, strongly under the spell of the Greenspan philosophy and was unwilling to put its trust on the relatively inexperienced Ms Born, accepted Greenspan’s advice. Derivatives continued to flourish unregulated.

Not wanting to sit on top of a time bomb, Ms Born quit as the head of the Securities Regulatory Authority.
About 10 years later, with the onslaught on financial markets by the global financial meltdown, the predictions and fears that Ms Born articulated on derivatives came home to roost. Top US decision makers belatedly realised Ms Born’s very good advice was mistakenly not taken by the US administration. It was too late.

Recently Al Jazeera TV broadcast a program on derivatives and interviewed Ms Born on what she articulated about derivatives during her tenure as the Securities regulator. She held firm to the views she expressed at that time and sadly reflected that a lot of the financial pain the world had to endure, could have been avoided or minimized if only the US administration had paid heed to her advice. Al Jazeera TV also interviewed Greenspan who is now in retirement.

He confessed that Ms Born was absolutely correct in her assessment of derivatives and that his laissez faire financial model of allowing unregulated financial markets to operate unrestrained, was seriously flawed .

Sadly derivatives are still being bought and sold and I can only recall Lord Acton’s profound words of wisdom “History repeats itself , once as a tragedy and then as a farce.”

Futures vs Options
Derivatives Demystified (Part 2)

By Upul Arunajith

Futures Options

Margin Deposit Yes No

Term / Expiration Yes Yes

Premium Payment No Yes

Price guarantee Yes Yes

Participate in market downturn No Yes

Daily Settlement Yes No

Structure of a Futures Contract:

A Futures contract is a structured
Forward contract in terms of:

4 quantity

4 quality

4 price

4 delivery date

Margin Deposit:

Futures contract trades in an organized exchange and guaranteed by the clearinghouse corporation. To guarantee the performance of the contract both parties to the contract (“buyer” and “seller”) are required to place margin deposits (= a deposit of good faith). Two types of deposits. “Initial margin” and “Maintenance margin”.

When the market moves in favour of the investor the gains will be deposited to your account. When the market moves against you the losses will be taken out of initial margin account and the account holder replenishes the margin deficiencies immediately. If the market moves adversely against the investor, the broker will make a Margin Call asking the investor to place more margin in the maintenance margin account as additional security.

Failure to comply with a margin call will lead the clearing house to cash the security held in the margin account and closing the Futures trading account. Unless cash flows are strong, market spikes can lead to whiplashes and the reason why Futures trading is not in the realm of the retail investor. Prolonged margin deficiencies will wipe out the commodity trading account.

Pricing a Futures Contract:
Futures contracts are priced based on Cost of Carry (COC) model. Basically what it involves is the

4 cost of funds

4 insurance

4 storage

4 cash flows during the term until the trade is consummated.

Futures contracts lock in the futures delivery price as these contracts are guaranteed by the clearing house and The mark to market is settled daily.

Settlement: Futures price locks in the final delivery price and the parties to the contract cannot move away from the Futures contract obligation.

(To be continued)


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