There are two sidewalks on Wall Street. One is well lit with plenty of regulation to give even the least experienced pedestrian a fair chance at growing their investment. The other is more dangerous, darker and less regulated, easily tripping up even the most experienced investors. Welcome to the darker side of the derivatives market.
Derivatives are a broad category of investment vehicles that have been stigmatized with a bad reputation for being difficult to understand, challenging to price, and risky to trade. The real danger with derivatives is that they have very few rules governing their trade, and are much like the Wild West of the investment world.
They have brought down bank after bank, including the infamous Lehman Brothers which triggered the global financial crisis of 2008.
Regulators have promised to bring more order to that “anything goes” culture of derivative markets. Yet some worry it will only push the varmints into the darker corners of the marketplace.
The Dangerous Nature of Derivatives
As Investopedia defines it, a derivative is “a security whose price is dependent upon or derived from one or more underlying assets”, “a contract between two or more parties [whose] value is determined by fluctuations in the underlying asset”.
Essentially, a derivative is just a piece of paper that represents another investment – such as a futures contract or an option that is based on another investment like gold, crude oil or even stocks. The buyer of such a contract is not buying the actual gold, oil or stock represented by the derivative, but is investing in the derivative itself.
And therein lies the risk – and stigma – associated with derivatives. Even though the price of the derivative “should” move similarly to the underlying investment it represents, it doesn’t always do so because the derivative is now its own investment vehicle, trading on the open market according to its own supply and demand forces.
If the safety of a derivative is ever brought into question – say by a company’s failure to meet one or more of its obligations, or its failure to deliver at the time the contract matures – then the value of the derivative could plummet, even if the price of the underlying asset it is based on remains the same. Supply and demand can cause the value of a derivative to deviate from the value of the asset it represents – sometimes for better, but usually for worse.
So while derivatives are supposed to shadow the performance of another investment like your own shadow is supposed to follow you, investors must always remember that a derivative is its own investment vehicle with a mind and will of its own. It is as if your shadow suddenly becomes its own living entity, capable of going its own separate way and leaving you behind.
Not All Derivatives Are To Be Feared
We mustn’t suspect all derivatives, since most are perfectly safe to trade. In fact, without even realizing it, every investor trades derivatives with every trade they place. How? Simply by using dollars. Money is itself a derivative, a promissory note issued by a government, whose value is derived from the reserves in its vaults and the performance of its economy.
Now it is true that many investors are similarly sceptical of “fiat” currencies for the very reasons listed in the previous heading; just as the value of a derivative can deviate from the value of its underlying asset, so too the value of a currency can become disconnected from its assets through overprinting or misleading accounting. Nevertheless, cash is at least one leg in almost every trade, sometimes both legs as when trading FOREX. Investors use derivates all the time without any problems.
Even a stock technically satisfies the definition of a derivative, since its value is derived from the value of a company’s assets and future profit potential, which can deviate sharply by the stock’s own supply-demand fundamentals and investor sentiment. But you don’t see people avoiding equities simply because they are paper certificates whose value is derived from something else.
Neither should we as investors be afraid of all derivatives, which come with varying degrees of deviation risk. What is more, the government is promising to step in with measures to make derivatives safer.
Shining More Light into the Shadows of Derivatives
The real danger zone in derivatives trading is in the OTC (Over-The-Counter) Market, where banks and investment institutions trade such instruments as forward contracts, swaps and bonds, in addition to stocks, futures, and options.
The main difference between the OTC market and your typical stock exchange is that there is no middleman between buyer and seller at the OTC. Where trades between a buyer and seller on an exchange are handled by a clearing house which matches buy orders with sell orders, trades on the OTC are performed between the buyer and seller directly, often even over the phone by simply talking with each other.
The nature of these “bilateral” trades affords a great deal of flexibility, allowing the two parties to negotiate all kinds of details, such as what specifically is being traded, its quality, its size, its delivery date, and of course its price – all of which is up to the buyer and seller to determine for themselves. It’s kind of like an e-Bay for institutional investors.
As such, we can easily see the potential for danger. What if the seller doesn’t deliver the agreed upon quality at the agreed upon time, or doesn’t even deliver at all? What if the buyer’s payment isn’t made on time or is never made at all?
And we’re not talking about just a handful of trades going bad, here. We’re talking about $700 trillion worth of financial products changing hands on the OTC each year, where the same contract can change hands dozens of times from one bank to another all around the world. If just one major institution fails to deliver on its OTC deals, such as Lehman Brothers did a few years back, we could have a repeat of the 2008 global financial crisis all over again.
The 2010 Dodd-Frank package of legislation intends to reduce such default risk in the OTC market by requiring more collateral to secure the deals made there, as well as introducing new rules between buyers and sellers, and even introducing clearing houses to act as middlemen such as regular exchanges use.
But critics of an OTC clearinghouse and higher collateral requirements warn that banks and investment companies will simply venture deeper into the “shadow market”, where they can continue to deal on their own terms, merely shifting the risk from one market to another.
“It’s somewhat problematic as these [clearinghouse] structures are fragile and can break in a crisis,” Jonathan Herbst, a partner at law firm Norton Rose Fulbright, cautioned the Financial Times.
“The regulators didn’t really think about where the collateral is going to be coming from,” Craig Pirrong, finance professor at the University of Houston informed FT. “It’s going to be coming from the banking system and, crucially, the shadow banking system.”
This will affect institutions like pension funds and hedge funds that do not have access to cheap money from the Federal Reserve as the banks do, driving them into the even less regulated “third” and “fourth” markets, deep in the recesses of the financial system where even less regulatory light shines.
Investors Avoid the Drama
Individual investors need not be distracted by the battles that rage in the derivatives arena, even if we like to use derivatives such as stock futures and options. Average investors do not have access to the OTC market, and are not exposed to the financial viruses that circulate there.
Even so, we should research our holdings to determine how much exposure they have to the shadier side of the derivatives street. Generally it is the larger banks, pension funds and hedge funds that are active in the Wild West of the OTC market. So if another Lehman Brothers style of collapse concerns you, you might wish to stick to the smaller banks or opt for a financial ETF to spread your risk across the banking sector.
Just don’t let the stigma associated with derivatives dissuade you from all such investments, as they are not all the same. Do you think a stock is going to soar in the coming year? Buy a call option on it. Do you think the market as a whole is going to crash? Buy a put option on the S&P index. These are just two derivatives that you can trade with no disconnect between the option’s performance and that of its underlying stock or market.
Futures contracts and options on stocks are very viable investment choices, regulated and controlled by exchanges and clearing houses, and can be great tools in the management of risk in any portfolio.
Joseph Cafariello
