2 views on derivatives

I follow the events in World Economic Forum in Devos closely to update myself on the economic happenings around the world. On 28 Jan 08, the newspaper reported an interesting exchange between a politician and an investment banker on derivatives.

During that exchange, the financial world was still recovering from the shock created by the SocGen's 4.9 billion euro trading fraud. Mr. P. Chidambaram, India's Finance Minister, held strong view that the current global credit crisis is the result of unscrupulous usage of complex financial products that "most people don't understand". He was referring to derivatives.

On the other side of the panel is Mr. Jerry del Missier, president of Barclays Capital. Mr. Missier held equally strong view that derivatives have their merits (primarily as a risk hedging tool), and we will continue to see growth in users and innovation and he thinks derivatives will be one of the key drivers of the next phase of economic growth cycle.

As a bystander of world economic and financial affairs for many years, I have to agree with Missier's view. Derivatives will play an important role, like it or not. My view is not so much based on the technical merits of derivatives, but rather on my observation of human nature. It is human nature that we tend to draw towards something that will magnify wealth with least effort. It is also in human nature that we are driven by greed. Derivatives nicely satisfy these two human natures (unfortunately).

I remembered in 2003, i attended a seminar on CDOs (a form of derivatives). The speakers were accomplished investment bankers and economists. CDOs then were described (and promoted) as the "perfect" product to achieve high yield and provide safe volatility relative to equities. Subsequently, in 2004 - 2006, I read that the amount of institutional funds that go into CDOs were mind boggling. In 2007, we know the story of CDO crisis.

Financial options and futures (common derivatives) allow corporations to hedge their risk against price volatility. Speculators have other ideas. They use the technical merits of options and futures to magnify their personal wealth. Some have treated the stock market as a gigantic casino.

More accomplished speculators went one step further. They use leverage (i.e. borrowed money) to run their derivatives operations. In 2008, we know the story of SocGen.

There will be more stories to come. However, instead of avoidance which is impossible because of human nature, it would be wiser to study and understand derivatives to put them under control.