1 August 2019

Derivatives: The long road to redemption

Once viewed as precarious and immoral, today they are an essential financing tool. What changed?

Photo by Karolina Grabowska from Pexels

By Belmont NewsBeat

Ten years ago, in early-2009, the true villain of the great financial crisis emerged. 

Not the local US banks, who zealously lent to impoverished American homeowners, knowing that most were unable to meet their repayments. 

Nor was it the US Government, who through the Community Reinvestment Act encouraged lenders to provide home loans to subprime borrows.

While it could be argued that both parties must share some responsibility, neither brought the global financial system to its knees. 

“Food stamp recipients didn’t cause the financial crisis,” quipped former US President Barack Obama. “Recklessness on Wall Street did.”

‘Significant failures’

In the build-up to the crisis, mortgage-backed securities — over-the-counter (OTC) derivative products where lenders act as middlemen between subprime borrowers and institutional investors — had become talk of the town. Positioned as a win-win for all, borrowers accessed capital they would otherwise have been unable to obtain; investors benefitted from burgeoning demand for loans with high returns; and banks made handsome commissions in-between.

To help sell these highly profitable securities to investors — namely pension funds, insurance companies, mutual funds and hedge funds — banks chopped up the mortgages and sold them in tranches. Along with various other features, this veiled their low credit quality. 

To hedge their purchases, investors sold credit default swaps — also OTC derivatives — to shield them from losses should these mortgage-backed securities default. Or so they thought.

Wall Street quickly became awash with these deals. At the time, firms were typically holding leverage ratios of between 24:1 and 33:1. So when in late-2018 high interest rates began to bite subprime homeowners, with many failing to meet their repayments, mortgage-backed securities began to default en masse, leaving both investors and banks exposed. 

“The financial crisis involved significant failures in the functioning, regulation, and supervision of OTC derivatives markets,” bemoaned Jerome Power, then member of the Board of Governors of the Federal Reserve System, and today’s chair.

Regulatory crack-down

The rest, as they say, is history: A slew of firms going under globally, made famous by the fall of Lehman Brothers, accompanied by government bailouts on a colossal scale. The costs of the crisis to the US that year topped US$600 billion — Warren Buffet wasn’t wrong when he once labelled derivatives “financial weapons of mass destruction”.

When questioned on the cause of the meltdown, Mary Schapiro, Chairman of the Securities and Exchanges Commission, cited “A siloed financial regulatory framework that lacked the ability to monitor and reduce risks flowing across regulated entities and markets.”

What happened next was to be expected. Regulators cracked down on OTC trading, with firms, particularly in Europe and North America, being forced to move their activities to regulated trading venues. 

In the meantime, however, Asia did what Asia always does, which, according to Refinitiv’s Jonathan Woodward, is to “Carry on as if nothing has happened.”

Why shouldn’t they, many asked, as it wasn’t their fault the global financial system came to a standstill. Firms were confident the region could thrive unchanged.

Towards centralisation

Asia continuing to doing things differently was never going to last.

With pressure from overseas counterparts, due to global interconnectivity and more recently the advent of MiFID II last year, Asian firms slowly but surely turned to centralised, regulated venues — a move participants commonly bemoaned, believing they were at a disadvantage with most trading taking place during Western trading hours

Present-day research, however, says otherwise. 

According the Futures Industry Association, Asia is now the largest market for exchange-traded derivatives, accounting for 11.2 billion contracts in 2018, with 30.28 billion transacted elsewhere. 

Furthermore, between 2014 and 2017, average daily volumes executed by Asian participants on CME Group exchanges experienced compound annual growth of 9% — across interest rate, FX and metals products. Proof that interest in exchanged-traded derivatives is burgeoning, and that there is a legitimate role for these instruments.

Transparency, liquidity and diversification

Futures, in particular, exert significant benefits for corporates and financial firms. 

Used for risk management and hedging, as well as for portfolio diversification, futures present high levels of transparency, liquidity and diversification for investors seeking solutions beyond conventional stocks and fixed income.

“Trading in futures provides access to a whole host of asset classes ranging from interest rates, equity indexes, foreign exchange, energy, agricultural products and metals — without having to forego liquidity and transparency in the way other financial instruments do,” enthused CME Group’s Christopher Fix in an op-ed published by Institutional Investor.

“It is also a powerful diversification tool as some of these asset classes exhibit very little correlation to traditional bond and equity markets, while at the same time remaining highly liquid.”

Asia rising

With macroeconomic developments taking place 24/7, Asia is capitalising. 

When news of Brexit broke in the early hours of 24 June 2016, for instance, only Asia was open. Of the record 44 million contracts transacted globally that day, CME Group data shows, 40% — or 18 million contracts — were transacted during Asian trading hours, much more than the global average daily volume.

“With the world becoming increasingly inter-connected, global events that take place can have reverberating effects on the other side of the globe, and split-second decisions need to be made as events unfold.” Fix continued. 

“We expect that Asia will continue to grow in its influence on the global derivatives market in the years to come.”

Has this decade-long road to redemption reached its end? One must hope, at least.

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