Page 2 of 5 DERIVATIVE MARKET REFORM, Part 1 The folly of deregulation
By Henry C K Liu
emboldened dishonest managements to lie with impunity by relieving them of
concern that those to whom they lie will have legal recourse. The Statute also
seems to shield underwriters and accountants from [legal accountability for]
lax performance." He added that "no major financial fraud in the United States
in the last 10 years was uncovered by an outside accounting firm."
Financial innovation propelled the development of the derivative market, which
in turn became a fertile field for abuses that have caused serial financial
crises around the world since 1994, starting with the Mexico peso crisis and
going on to the collapse
of 233-year-old British firm Barings in 1995 from the billion-dollar loss
incurred by derivative trader Nick Leeson, the 1997 Asian financial crisis
detonated by the Thai central bank's inability to sustain the fixed exchange
rate of the overvalued baht, and the 1998 financial crises in Russia and Brazil
that froze global markets briefly and subsequently caused interconnected
markets to crash in locked steps.
While each of these crises had it own particular roots, the vehicle that caused
market failure in all cases was derivative trading.
Exchange traded and OTC derivatives
Derivatives tighten the connectivity between markets and enhance market
efficiency, but they do this by increasing systemic risk globally if left
unregulated.
Exchange traded derivative contracts are generally standardized, and investors
are protected against fraud and default by transparency and the financial
reserves of the exchange. OTC derivative contracts are uniquely structured and
traded directly between contracting parties with full assumption of risk of
counterparty default. Many large financial institutions, including big banks,
generate handsome fee by acting as a private clearing houses for OTC derivative
contracts. However, OTC derivatives traded by large financial institutions that
also trade with other large financial institutions present systemic risk to the
whole interconnected market.
Yet many policymakers and legislators still do not have a clear understanding
of the nature of financial derivatives or how the derivative market actually
works. While the destructive potentials of financial derivatives have been
recognized since their invention 36 years ago, most regulators still lack the
full understanding needed to design effective regulation for the derivative
market, particularly the OTC derivative market. As a result, they tend to
accept the myth of self-regulation as the best, albeit still imperfect,
solution propagated by influential free market ideologues.
This is because the innovation-driven workings of the OTC derivative market are
constantly evolving out of the public eye, making it difficult for anyone who
is not a direct market participant in bilateral counterparty contracts to
develop effective regulation to protect the financial system from
derivative-induced systemic meltdown and to protect the general public from
risks of loss.
Yet, bilateral derivative contracts are hedged through interconnection
throughout the entire market. These contracts manage unit risk by transferring
it to systemic risk. Thus regulation needs to be focused not just on size but
also on the location of strategically placed fire breaks to prevent systemic
contagion. Such systemic contagion can travel without even a direct physical
connection. During the 1997 Asian financial crisis, speculators sold in strong
but highly liquid market in futile attempts to save distressed position in
illiquid markets, bringing the entire global market down.
Individually benign, systemically dangerous
Derivatives, whose values are derived from underlying assets, are not by
themselves toxic financial products invented by evil financial wizards. They
are rational instruments for unlocking latent value in financial transactions
through mathematical logic.
With precise measurement of derived value and immaculate logic in risk
management, full potential net value can be effectively captured for both the
participating parties and the economy as a whole that otherwise would be left
untapped in conventional financial transactions. By definition, value creation
is a positive contribution, but only net value creation after taking into
account risk of loss can be a positive economic contribution. Creating or
capturing value via unknown risk is merely gambling with luck.
Derivatives, by their opaque nature, only hide risk by dispersing it, but not
by extinguishing it, allowing the risk to stay invisibly in the system, thus
creating a false sense of safety. Such instrument structurally under-price risk
by only hiding it. (See The
Danger of Derivatives, Asia Times Online, May 23, 2002.)
A derivative, being a financial instrument that derives its value from an
underlying asset, is a sophisticated vehicle for pricing derived values that
are affected by market risks. Rather than trading or exchanging the underlying
asset itself, derivative traders enter into contractual agreements to exchange
cash flow, or assets of equivalent value, over time based on expected future
value of the underlying assets. A futures contract is an agreement to exchange
the value of an assumed underlying asset at a future date, but not necessarily
the physical asset itself. Thus was born the concept of notional value in
derivative structures.
The use of leverage
To capture minute change in value, derivatives are routinely structured with
high leverage, so that a small movement in the value of the underlying asset
can cause large changes in the value of the derivative contract. This leverage,
coupled with the astronomical growth of the OTC derivative market, has turned
many financial institutions that participate in this market into "too big to
fail" entities, the failure of which can cause serious systemic impact,
allowing them to expect government bailout by holding the financial system
hostage in a distressed market to prevent systemic collapse.
Thus the "too-big-to-fail" syndrome leads directly to heightened moral hazard.
Still, leverage is the music of the derivative market. Without access to
leverage, the derivative market will have no dancers.
The net capital rule created by the SEC in 1975 required broker-dealers to
limit their debt-to-net-capital ratio to 12-to-1. After the rule was exempted
in 2004 for five big firms, many hedge funds increased their leverage to
40-to-1 to maximize profit by enlarging the risk profile by trading with the
big five. (See The
zero interest rate trap, Asia Times Online, January 22, 2009.)
Moral hazard generated by the "too-big-to-fail" syndrome distorts the risk
management role of derivative structures. It turns the hedging function of
derivative into profit centers derived from an under-pricing of risk for
unsustainable gains.
The solution to the "too-big-to-fail" dilemma intuitively lies in preventing
institutions from getting too big. Yet because of the interconnection of
markets, even failure of small entities in large numbers can trigger systemic
failure. This gives even larger numbers of small entities of similar risk
profile, but each not too big to fail individually, the ability to cause
systemic failure.
In mathematics, the theory of large numbers includes the phenomenon of
unsustainable exponential growth, which occurs when the growth rate of a
mathematical function is exponentially proportional to the function's
escalating value. Such exponential growth is mathematically unsustainable and
will eventually implode. Malthusian population theory is based on the
un-sustainability of exponential growth.
Multilevel marketing is designed to create a fast-growing marketing taskforce
by compensating not only for sales it generates but also for the sales of other
new marketing taskforces introduced to the company by each existing marketing
taskforce, creating a limitless down-line of distributors and a hierarchy of
multiple levels of compensation in the form of a pyramid, such as that employed
by Amway Corporation. The crisis in subprime mortgage was caused by massive
network marketing, even as each subprime mortgage individually is only a small
contract.
No bank, however big and well capitalized, can withstand the onslaught of a
systemic breakdown of market-wide counterparty exposure built by multilevel
marketing of liabilities such as subprime mortgages and their securitization.
Thus the problem of systemic market failure is caused not merely by unit
bigness, but also by the absence of firebreaks to prevent exponential growth
and the resultant systemic contagion effect of large number failures from
chained counterparty reaction. It is hard to understand why policymakers are
not cognizant enough of this obvious fact to focus on the need for firebreaks
in interconnected financial markets, both to prevent the buildup of risk chain
reaction and to contain systemic failure contagion.
Options and hedges
In finance, options are derivatives because they derive their value from an
underlying asset. An option contract is an agreement between a buyer and a
seller that gives the buyer the right, but not the obligation, to buy or to
sell a particular asset on or before the option's expiration date at an agreed
price. In return for granting the option, the seller collects a payment or a
consideration from the buyer.
Options can be used to speculate for profit or to hedge risk. The classic model
of hedging, originally developed in 1949 by Alfred Winslow Jones (1910-1989),
takes long and short positions in equities simultaneously to limit exposures to
volatility in the stock market.
Jones, an Australian-born, Harvard and Columbia educated sociologist turned
financial journalist, came upon a key insight that one could combine two
opposing investment positions simultaneously: buying stocks and selling short
paired stocks, each position by itself being risky and speculative, but when
properly combined would result in a conservative portfolio that could yield
market-neutral outsized gains with high leverage.
The realization that one could couple opposing speculative plays to achieve
conservative ends was the most important step in the development of hedged
funds, a term coined by a 1966 article in Fortune to describe the fund run by
Jones.
The manipulative power of options lies in their versatility. Options enable the
buying party to adapt or adjust its position to handle any future situation
that may arise. Options can be used speculatively with risk or protectively
against risk to fit the buyer's desire. This means an option buyer can do
everything from protecting a position from decline to outright betting on the
movement of a market or index for gain. Options are therefore merely passive
versatile financial instruments. The users of options determine their purpose
for their use.
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