hot zones | DERIVATIVES
Crossing the Chasm
DERIVATIVES IN THE NEW ERA
Once upon a time, derivatives were simple. They were risky and evil and the source of countless disasters, such as Orange County, Barings Bank, and Long-Term Capital Management. The customized contracts that traded in the loosely regulated OTC (over the counter) market or the standardized contracts that traded on the more heavily regulated exchanges (the “listed” market) were highly levered and were often misunderstood and misused. Derivatives were vilified by the press and much of the investment community. Warren Buffet’s famous reference to “financial weapons of mass destruction” was bandied about. Derivatives were treated not as tools that could be used (or abused), but as instruments inherently distasteful in and of themselves.
As Wall Street confronts perhaps its most significant economic challenge since the Great Depression, derivatives could be singled out as the villain of the piece. However, in an interesting turn of events, the market has chosen to lambast not the derivatives themselves, but investors’ and managers’ use of derivatives. That may seem insignificant, but it’s critically important. It might herald a new era in which centralized trading and enhanced transparency allow the use of derivatives products to hedge exposures and enhance returns in a responsible manner. (As opposed to, say, creating investments with 30 to 1 leverage.)
In this brave new world, the best characteristics of OTC and exchange-traded markets would converge. Derivative contracts with either flexible or standardized terms would trade on an organized platform with transparency and a healthy dose of regulation and oversight. Contracts would be backed by a centralized clearing organization and margins would be posted by both buyers and sellers. Bids and offers for these securities would also be posted, so current prices would be easily ascertained.
Can this castle in the sky be built in today’s complex investment environment? Well, the chasm between OTC and exchange-traded products is already narrowing. “Flex” options offering flexible-term contracts in an exchange-traded environment are available, but have yet to experience growth rates commensurate with their potential. More efficient documentation of OTC transactions, earmarked by the New York Federal Reserve Bank and implemented by the ISDA (International Swap Dealers Association), has created more standardized language that will help clear up back-office snafus and enhance the fungibility of OTC contracts. As each market adopts some of the positive attributes of the other, a melding of characteristics begins to take place.
What will the incredible turmoil facing the market do to this promising development? To date, the OTC derivatives have the edge in volume (Chart 1). But going forward, the major disadvantages of OTC derivatives transactions (counterparty credit risk, lack of transparency, and difficulties determining current market valuation) will result in a greater flow of new business to exchange-traded derivatives. How much business shifts to the listed markets will probably be determined by how effectively the OTC markets can incorporate the positive characteristics of the exchange-traded products. Government mandates are likely to play a role here.
Chart 1: $677 Trillion in Worldwide Derivatives
Notional Principal in US$T—Amounts Outstanding
A transition from OTC to listed markets may involve the migration of a major segment of the OTC market to an exchange-traded format such as the rapidly expanding CDSs (credit default swap), which are at the root of many of today’s challenges (Chart 2). Although exchange-traded CDSs are already offered by the CBOE (Chicago Board Options Exchange), they have yet to really take off. Market participants are reluctant to part with the no-margin/no-transparency world of OTC trading. As current events play out, and the government makes its “suggestions,” a catalyst for a sustainable exchange-traded CDS product may emerge. This would provide regulation, credit guarantees, and transparent pricing for a rapidly growing segment of the derivatives markets.
Chart 2: $58 Trillion in Credit Default Swaps
Notional Principal in US$T—Amounts Outstanding
If the US does revolutionize its derivatives market, will the rest of the world play along? The global market for derivatives is not homogeneous. In the equity and equity-index option space, OTC contracts are far more popular in the European marketplace than in North American trade (Chart 3 and Chart 4). The ingrained presence of OTC derivatives in Europe means that change will come more slowly there. However, the market forces behind the evolution of derivatives are so immense that the European market too will probably succumb.
In Asia Pacific, derivatives use is modest in comparison to the US and European markets. However, Korea is home to the most actively traded index option in the world—the KOSPI 200. In principle, Asia has already embraced derivatives. It should adapt swiftly to changes in the more active derivatives markets.
Chart 3: $63 Trillion in OTC Equity Options
Notional Principal in US$T—Amounts Outstanding
Chart 4: $63 Trillion in Exchange-Listed Equity-Index Options
Notional Principal in US$T—Amounts Outstanding
Sources for all charts: Bank for International
Settlement and CBOE.
And adaptation is the name of the game. Investors today simply cannot buy stocks and AAA-rated bonds and sit back waiting to perform on par with their peers. Unhedged commodity prices, exchange rates, and interest rates will play havoc with corporate bottom lines for decades. Derivatives can reduce risk and provide opportunities to enhance returns. Whether the bulk of derivatives will trade on exchanges or the OTC marketplace is hazy. But it’s clear that derivatives are no longer the ne’er-do-wells of yore. Risk management and transparency will be the watchwords of derivatives use in the future. The change will be for the better.
Walter V. Haslett is CEO of Miller Tabak Capital Management and director of option analytics for Miller Tabak & Company, LLC.
