Concern over Derivatives

▪ 1996

by Patricia Tehan

      Derivatives had been acquiring a bad name even before the collapse of the London-based merchant bank Barings PLC in February 1995 rocked the world's banking community. But the failure of Barings brought derivatives into the public spotlight after Nicholas Leeson, a 28-year-old trader in Singapore, accumulated losses of over $1 billion by trading futures contracts on Asian markets.

      Derivatives are contracts that have value that is linked to, or derived from, another asset (known as the underlying asset), which can include stocks, bonds, currencies, interest rates, commodities, and related indexes. Purchasers are essentially wagering on the future performance of that asset. The economic rationale of derivatives is that they provide a means of transferring and spreading risk and of accommodating risk-management needs more accurately and economically than conventional financial instruments. Though they can offer substantial advantages to those seeking to reduce financial exposure to a fall in prices, derivatives also can be very risky. Initial reaction to the Barings debacle was that given the growing use of such products, it would have been only a matter of time before they led to such a disaster.

      In the 1980s the case of some U.K. local authorities' involvements in options-based derivatives contracts first brought them into bad repute. The highest profile was London's Hammersmith and Fulham council, which suffered huge losses on derivatives contracts as interest rates moved against it. The contracts proved to be unenforceable, however, when the House of Lords ruled that local authorities did not have the power to enter into swaps contracts.

      There had been some high-profile corporate losses involving derivatives in 1994, involving Procter & Gamble (P&G), the U.S. consumer-products company, Metallgesellschaft AG of Germany, and Orange county in southern California. In early 1995 U.S. regulators started to raise concerns about the way derivative products were being sold to investors. This was the issue behind the argument between P&G and Bankers Trust, which designed its investments, and between Orange county and its broker, Merrill Lynch & Co.

      Despite the bad name that derivatives were beginning to acquire, the collapse of Barings was due to losses caused by a lack of adequate internal controls over an employee's proprietary trading activities. The highly publicized corporate disasters were caused by different circumstances. Ironically, it was the collapse of Barings, caused by trading in the tightly controlled futures market, that served as a means to focus attention on the products and prompted market participants to consider certain national and cross-border issues related to the structure and operation of the international markets for derivatives trading.

      Derivatives are not a new concept, but growth in their use has been dramatic over the past 20 years. This growth reflected a globalization of—and an increase in volatility in—financial markets, as well as a reduction in foreign-exchange controls. Volatility in interest rates, exchange rates, and asset prices created a climate of uncertainty. By using derivatives, corporations, foreign-exchange traders, and other investors were able to manage, control, and hedge risk.

      Derivatives include such widely accepted products as futures, options, and swaps. Standard derivatives contracts—those involving standard maturity, contract size, and delivery terms—are traded on exchanges such as the Chicago Board of Trade, the London International Financial Futures and Options Exchange, the Marché à Terme des Instruments Financiers (the French exchange), the Singapore International Monetary Exchange, the Deutsche Terminbörse (the German exchange), and the Tokyo International Financial Futures Exchange. Once the transaction has taken place, the contractual relationship is between each original counterparty and the exchange or clearing house. Customized contracts—those tailored to meet a specific customer's needs—are unregulated and traded in over-the-counter (OTC) arrangements. In OTC contracts the counterparties remain exposed to each other for the life of the contract.

      Debate in the months preceding the collapse of Barings was over how much derivatives were a tool to be used to provide flexibility in an investment portfolio and to reduce the risks being taken on by investment banks and their customers and how much they were becoming a threat to the stability of markets. The debate after the Barings failure focused the attention of investors on risk. The popularity of more complex derivatives contracts waned, while turnover in simple, less complicated futures and options products increased. After several months of panic, which saw a reduction in the volume of derivatives trading and a subsequent reduction of the number of players on some trading floors, markets settled down by the end of the year. Meanwhile, institutional and corporate derivatives users took a fresh look at their controls and revised their practices.

      At a 1994 meeting in Windsor, England, securities regulators from 16 countries agreed on measures to strengthen supervision of futures exchanges and improve the flow of information across international markets and to ensure that any problems that did arise could be contained locally to prevent an international domino effect. The initiative, brought about by the Securities and Investments Board of the U.K. and the Commodity Futures Trading Commission of the U.S., recognized that no one market supervisor has the full picture about traders who are operating globally.

      In a separate move, the Basle Committee of international banking supervisors published proposals designed to help banks avoid losses from adverse market movements. It also joined forces with the International Organization of Securities Commissions to issue new joint guidelines on derivatives for national regulators. The effect has been a gradual tightening of monitoring and enforcement.

      The horror stories of 1994 and 1995 resulted from imprudent use, lack of understanding, or lack of proper control of derivatives products and activities. In the case of Barings, inappropriate risk exposures were taken without proper guidelines or management controls. There was a complete failure to note the level of derivatives trading. In other cases there was a lack of understanding of the relationship between client and counterparty. All served to identify two issues in using the derivatives markets. The first was that players should examine the legal issues, including the nature of the relationships between the counterparties, ensuring proper documentation of transactions and ensuring that each side has the authority to deal. The second was a management issue, that those running an organization should have an understanding of risks being taken and be satisfied that proper operational controls are in place.

Patricia Tehan is banking correspondent for The Times, London.

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