Derivatives are not weapons of mass destruction

It is very fashionable to malign derivatives for doing so much damage to the global economy. Politicians and the media have labelled them as Weapons of Mass Destruction which are responsible for massive corporate losses and the downfall of companies such as insurer AIG and Lehman Brothers. Some have gone so far as to suggest that derivatives are one of the major contributing factors to the credit crisis and the wider global recession.

However, to blame derivatives is like blaming a car for causing a crash, rather than the driver who was drunk behind the wheel. The cause of the global recession is manifold and the reason for many corporate failures is varied too.

AIG was perceived as being reasonably capitalised but had massively over-extended itself in trading a particular kind of derivatives, called Credit Default Swaps (CDS).

There is nothing wrong with the concept of trading risk, but it requires that the party who accepts this risk holds sufficient capital to honour its obligations in the event of a default. In particular, it requires an acute appreciation of the measurement of risk associated with different types of derivatives. This appreciation was clearly not possessed by the bank regulators nor, it would appear, by those politicians and journalists who continue to treat all derivatives the same.

Examples of where derivatives are used every day to great effect are all around us. As an example, over 50% of all government sponsored Private Finance Initiative (PFI) transactions incorporate inflation derivatives. These inflation derivatives help to provide your local NHS Primary Care Trust (PCT) with a known repayment schedule for their refurbishment works. The PCT can then more accurately plan additional investment in front line services. Similarly, any corporate entering into a major investment would never consider leaving the bank loan supporting this expenditure unhedged, particularly at the current low level of interest rates.

The vast majority of derivative transactions, including the example above, are negotiated bilaterally. There are many voices who are currently calling for this trading — the OTC or "over-the-counter" market — to be heavily standardised, allowing for exchange-based trading. Unsurprisingly the exchanges themselves are lobbying hard for this, since they would stand to prosper immensely from hosting a $600 trillion market! However, this is unlikely to be in the best interests of the wider financial system.

One of the unique characteristics of OTC derivative contracts is that they offer the ability for a counterparty to take security on underlying assets —rather than having to invest cash upfront.

If inflation derivatives were traded on an exchange, our PCT would have to post large amounts of cash with the exchange to secure their inflation hedging. To give you an idea of the numbers involved, to hedge the inflation on a 30-year lease which currently pays rent of £1 million a year, the initial collateral required is likely to be somewhere between £2.25 million and £3 million. Costs such as these would probably be deemed prohibitive and the temptation would be to leave the risk unhedged. And as Shell and other major corporates have already testified, having to provide cash security for protecting their standard operating risks could greatly impact on their profitability. These kinds of cashflow events represent very real risks to a business, and will undoubtedly impact a company's decision as to whether or not it should make the capital investments required

In the last fortnight, the EU has joined the fray and also has the OTC derivatives market in its cross-hairs. Their suggestion is that OTC trading should be discouraged and banks that engage in the OTC derivatives markets should face higher capital charges. This idea cannot have come from anyone who understands the derivatives markets.

It must be understood that continuing flexibility in derivative structuring and application is paramount to effective risk management. For this reason, where derivatives are being used to hedge risk the OTC market remains the most appropriate forum, and should not be penalised. Regulators should instead consider the relative risks involved for each derivative market.