Derivatives: Financial Ingenuity or Ticking Time Bomb?

Well, there’s knowledge risk; that is, players do not understand the contracts they are getting into. How can we know the prices of assets in the future, today? Some argue that mathematics plays a role in pricing, but have you ever seen how complex the pricing formulas are? Considering that new forms of derivative contracts are invented almost daily, the calculations only grow in complexity.

Now consider that in 2009 the Bank for International Settlements valued the notional amounts of outstanding over-the-counter derivatives at approximately $800 trillion worldwide, more than thirty times U.S. GDP. When the market is this huge; yet lacks economic rationality, often opting for gambling on hunches, there’s reason to worry.

There’s also the accounting for derivatives. In the U.S., mark-to-market accounting is primarily used for derivative reporting. This means that worth of derivatives reported on balance sheets are partially based on the management’s estimates of what future prices may be.

Ethics aside, managers whose compensation depends on earnings may be tempted overestimate the value derivatives. In turn, this distorts true earnings but more importantly, places the company and shareholders in economic danger when these optimistic valuations fail to materialize.

Well, perhaps we can properly regulate the derivatives market? That’s easier said than done. How does one regulate the over-the-counter derivatives market; where there is a lack of a centralized system of exchange? Indeed, the Obama administration has taken some steps towards increasing transparency by forcing more trades onto exchanges and through clearinghouses, which guarantee the transactions and require dealers and corporate end-users to post collateral and meet daily margin requirements.

[pullquote]The risks involved with derivatives may not be properly understood even by the most sophisticated of investors.[/pullquote]

But when prominent businessman George Soros publicly remarked that the risks involved with derivatives may not be properly understood even by the most sophisticated of investors, how can we expect to define the problem and come up with a solution? How can we expect government officials to have the sufficient know-how to regulate these complicated markets, which are constantly evolving?

Can we maybe just let it be? Well, according to the Office of the Comptroller of the Currency, in the United States, the “top five institutions in terms of derivatives exposure—Citigroup, J. P. Morgan/Chase, Bank of America, Morgan Stanley and Goldman Sachs—hold over 95% of derivatives exposure of the top 25 U.S. bank holding companies.”

These same institutions have relied on the support of the public treasury during the recent financial crisis. This means that taxpayers have a direct interest in how the derivatives markets are structured and regulated. It’s unfortunate that the individuals most affected by the derivatives markets are those that understand it the least. The world cannot afford another financial crisis. But who can we turn to for the answer?

ARB Team
Arbitrage Magazine
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