Derivatives are starting to make a comeback

PUBLISHED : Tuesday, 02 March, 2010, 12:00am
UPDATED : Tuesday, 02 March, 2010, 12:00am

Billionaire Warren Buffett, the world's best-loved investor, once described derivatives as 'financial weapons of mass destruction'.

These may seem like strong words for what was originally a simple and practical means of securing food and provisions on a more or less stable basis without having to invade the neighbours. Without derivatives, human society, as we know it today, may have been different. Progress towards it would certainly have been much slower.

For conservative investors, who may not be too financially savvy, derivatives can seem complex and difficult to understand. A lack of solid understanding about them can lead investors to financial ruin. An example of this was when Lehman Brothers collapsed in 2008.

Thousands of Hong Kong investors in minibonds issued or backed by Lehman Brothers were left holding investments that had become almost worthless overnight.

Understanding the risk and rewards involved in derivatives is essential. The concept of derivatives dates as far back as the Mesopotamians who understood risk perfectly. In their case, the risk of ruination in the event of crop failure elsewhere.

Already conversant with the concept of futures, where trades were agreed and paid in advance for crops that had not even been sown, they added on the idea of hedging against potential loss by exchanging their risk against somebody else's - say a shipowner importing cargoes of persimmon.

The calculation of the value of these trades was derived, logically enough, from the asset to which it was directly linked - and thus was born the derivative, and with it the world of forward planning and non-militaristic societies.

The notion of humans pursuing ideas and endeavours beyond the provision of food, shelter and safety also enjoyed a quantum leap forward at this juncture.

But despite this, and all the bailouts, bank collapses and economic implosions, derivatives are making a comeback.

AIG last week announced its decision to keep up to US$500 billion of the same derivatives that were blamed for causing it to teeter on the brink of collapse.

Our own Hong Kong's Securities and Futures Commission has briefed investors its measures to make derivatives safer, and announced plans to offer RMB-based equity, debt and derivatives in Hong Kong.

It helps to remember that derivatives once enjoyed good press. As with the corporation and common stock, derivatives were conceived not in the cynical pursuit of exploitation and social mayhem, but as a practical solution to a problem that stood in the way of progress.

Diane Coyle, an internationally-renowned economist, with her own consultancy Enlightened Economics, and author of Sex, Lies and Economics and writer of the Enlightened Economist blog, is no defender of the recent abuses of the financial markets. She does, however, stress that derivatives still have a valid social role to play. 'Derivatives affect risk,' she says. 'When they work well, they can spread risk between many more investors or companies, both reducing their risk and sharing the burden, such as pension funds offsetting some of the risk of investing overseas, and importers and exporters covering themselves against volatile exchange rates.'

As to how the innocent and well-meaning derivative could find itself put to such dastardly use, Coyle is clear in her own conviction that more regulation is imperative, and that not nearly enough has been done to implement the necessary level of control.

'When derivatives work badly, they do the opposite of their original purpose. Some use of derivatives is essential, but the moral of the crash is that nobody should touch a derivative without understanding where the risks will lie.'

Citing John Lanchester's recent book on the 2008 crash, Whoops, Coyle points to the fall of communism in 1989 as one factor, due to its 'direct impact on the economy and financial markets, and its moral impact in removing an external constraint which had made capitalism kinder'.

Politics, she believes, played a far greater role in creating the conditions for the crash than has previously been acknowledged.

Although much blame is laid at the door of flawed mathematical models of risk and bankers creating financial instruments without the buttress of sufficient reserve capital, commentators, such as Coyle and Lanchester, attribute the failure of derivatives in our time to what Lanchester calls 'the industrialisation of banking'.

As for Coyle, she next pursues her own preoccupation with the economy's role in society in a public debate with, among others, the Archbishop of Canterbury.