Derivatives and the domino effect

It’s mean, it’s untamed and it’s three times bigger than the world economy. If ever there was the mother of all calamities waiting to happen, surely it must be in the global derivatives market. With £72 trillion in over-the-counter contracts floating around the globe, it doesn’t require much imagination to foresee the outcome once an unexpected event topples these corporate dominoes.

Fund manager Tony Dye warns of a “lurking time bomb” in the derivatives market, mainly related to the kind of creative accounting that brought down Enron and WorldCom. “The question is why people are using them so much,” he says. “It must be to do with creative accounting. My guess is that there will be some real nasties in derivatives in the next 12 to 18 months.”

Dye’s dire predictions may sound like scare mongering, but it is worth recalling that, as former chief investment officer at fund manager Phillips & Drew, he accurately foresaw the gathering clouds over the technology market and shunned TMT at a time when everybody else was piling in. This cost him his job, but within two weeks of his departure Nasdaq peaked and investors watched his grim forecasts come true.

What makes derivatives so dicey? In the first place, they are dangerous simply because most people don’t understand them. A classic scenario is an insurance company being sued by an investment bank when something goes wrong. The insurers think they have the right to review the corporate event that has triggered a default, while the bank thinks it has a contract with an indisputable trigger event. The problem is that there is no mutually recognised arbiter to resolve the dispute.

“It’s not just an event that can cause a derivative to be called,” says Norman Bernard, director of banking consultancy First Consulting. “Credit risk and delivery risk are inherent in derivatives. All you need are a few more Enrons going under and this would put at risk the balance sheets of otherwise stable companies.”

For instance, a company with a large part of its assets tied up in derivatives could at the very least find itself in a contentious situation in the event of a contested contract. The company may get paid, but the dispute could drag in a counterparty that is having problems of its own. All it requires is for a few transactions to go wrong, and many companies could be in deep trouble.

“Derivatives are a slice and dice game,” says Bernard. “People feel they recognise something they are prepared to take on board as risk, but it is not clear that this is being done correctly. You take out one piece, add another, measure this risk against that one, and so on.”

Derivative products are based on a value-at-risk calculation, which is an estimate of what is considered the outer limits of behaviour of these instruments. Banks calculate the worst-case scenario on contracts and bet on not getting a worse movement 99 times in 100.

The problem comes when that one-in-a-100 factor materialises. In that case, the possible outcomes are not well understood. Computer models are set up to notice when something goes wrong, but in a way this is like the Stealth bomber. It defies the laws of aerodynamics and shouldn’t work, but it has a computer program that on a microsecond-by-microsecond basis counters any adverse events. In the same way, companies trading in derivatives are flying in the face of historic reality: no one really knows what will happen when two or three large players have problems simultaneously.

Banks embraced derivatives in order to manage their portfolio of credit assets more effectively. Credit derivatives have spread to other users such as corporates and insurance companies, enabling them to transfer and exchange credit risks arising from any form of financial instrument, be it a loan, a portfolio of bonds or any underlying tradeable asset.

The idea is that credit derivatives allow a user to exchange risk without having to exchange the underlying asset.

But the market is littered with landmines. These include a lack of definition over what constitutes a credit event, footloose traders whose exclusive understanding of the market makes them difficult to monitor, poor controls, poor IT systems, incorrect pricing and a paucity of documentation. The anonymity of credit derivatives, such that companies do not know who is exposed to them, only exacerbates all this. It’s hardly surprising that experts are worried about what could happen next.