In Defense of Derivatives

Between Enron, WorldCom, and Global Crossing, the controversial financial instruments have gotten a bad rap. Here's the truth.

Three of the six largest bankruptcies in American history -- WorldCom, Enron, and Global Crossing -- occurred between December 2001 and July 2002, shattering investor confidence and helping to knock 22 percent off the Dow Jones Industrial Average. The failures had more in common than just timing and size: All to varying extents involved the use of the controversial and poorly understood financial instruments known as derivatives.

In the season of finger pointing that followed, derivatives trading was singled out for abuse. "If you dig deep enough into any financial scandal," BBC business reporter Emma Clark claimed in February 2002, "you can usually find a derivative or two to take the blame." Howard Davies, chairman of the U.K. Financial Services Authority, told a conference the month before that an investment banker described to him one popular type of derivative (collateralized debt obligations) as "the most toxic element of the financial markets today." Even famed investor Warren Buffett warned that derivatives posed a grave threat to the global financial system. "We view them as time bombs, both for the parties that deal in them and the economic system," Buffett wrote in his 2002 annual report for Berkshire Hathaway. "Derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal."

What are these Wall Street WMDs, and what should be done about them? Technically, derivatives are financial products whose value is "derived" from that of an "underlying" asset. For example, stock options, perhaps the best-known derivatives, are based on the underlying value of the stock that the option enables the purchaser to buy at a later date. Futures contracts -- used extensively by farmers to protect themselves from poor crop yields and fluctuating prices -- are derived from the root value of the good to be bought or sold in the future.

Derivative products are not just a sophisticated way for investors to gamble. They also give producers a crucial tool for hedging against risk and uncertainty. And they have played a central role in the flowering of innovation that the financial markets have enjoyed during the last two decades. There are derivatives betting on the likelihood of a natural catastrophe; consumer credit card debt has been converted into bonds; futures markets have been established for such things as barge rates; and options allow investors to speculate on the temperature, wind chill, and amount of rainfall in many cities.

The common denominator in all these products is that they allow companies and private investors to trade away risk with which they are ill equipped to deal and focus instead on taking risks in areas in which they specialize. Many international corporations, for example, use currency derivatives to swap out their exposure to exchange rate fluctuations. This allows them to focus on their core business while allowing professional currency traders to worry about international valuations.

This wave of financial innovation has washed into unlikely places. Glam rock pioneer David Bowie, long famous for his innovative music and embrace of the new, became the first songwriter in history to use derivatives to securitize future royalties from his own song catalog when he created "Bowie Bonds" in 1997. Bowie and his business manager, the Rascoff/Zysblat Organization, sold the royalty rights to his 25 pre-1990 albums to the Prudential Insurance Company. The singer/songwriter was able to pocket $55 million immediately, while Prudential received a 7.9 percent return on bonds that were backed by Bowie's future royalty payments. Bowie's groundbreaking move was quickly emulated by James Brown, the Isley Brothers, Ashford and Simpson, Joan Jett, and other artists, as well as the estate of Marvin Gaye. Bowie Bonds even inspired a thriller novel, Something Wild (2002), by Linda Davies.

But all has not been hunky dory for derivatives. Besides the massive bankruptcies, critics point to a number of other derivatives-related mishaps. In 1995 Nick Leeson used derivatives to establish positions for his employer, the British bank Barings, with exposure of more than $60 billion, compared to the bank's capital of $615 million. When the positions turned against Barings, the 233-year-old institution was forced to fold. The Long-Term Capital Management (LTCM) hedge fund and the government of Orange County, California, were also involved in derivatives-related meltdowns in the 1990s.

The Men Who Sold the World

Although sometimes viewed as a recent innovation, derivatives actually predate Christ. Thomas F. Siems, a senior economist at the Federal Reserve Bank of Dallas, claims that the Greek philosopher Thales created the first known derivative contract roughly 2,500 years ago. Thales, apparently an excellent prognosticator, suspected that the olive harvest would be exceptionally good one year, so he bought options securing him the exclusive use of olive presses in his area. When the harvest turned out to be much as Thales had expected, he made a tidy profit renting out his monopolized presses for high fees.

A regular market for such sophisticated financial instruments existed in Europe as early as the 1600s, when short sales, options, and forward contracts all were exchanged on the Amsterdam bourse. The Dutch government was so skeptical of these mysterious goings-on that it passed laws making derivative contracts unenforceable in government courts. Economist Edward Stringham of San Jose State University has demonstrated that despite such official disapproval, the Amsterdam derivatives market worked in an orderly fashion, relying on privately created law and ostracism of those who didn't fulfill their contracts.

Still, derivatives played a relatively minor role in global financial markets until fairly recently. It was not until 1973 that the Chicago Board Options Exchange began trading listed options in the United States. From 1982 to 2000, trading in listed equity options increased roughly tenfold, spurred on in part by the pioneering work on options modeling by economists Fischer Black, Robert Merton, and Myron Scholes. As sophisticated mathematical models for valuing derivatives gained currency, computers came to play an increasingly important role in trading them. The fall in the price of computing power consequently enhanced the popularity of derivatives.

While trading in stock options was increasing, both the volume and variety of other types of derivatives were growing explosively. Between 1987 and 2002, the amount of outstanding currency and interest rate swaps and options increased from $865 billion to nearly $100 trillion, according to the International Swaps and Derivatives Association. (Swaps are agreements where two parties agree to exchange some features of two assets without trading the assets themselves. For example, a bank that holds many fixed-rate loans but wishes to obtain more floating-rate cash flows might swap the cash flows on some loans with another bank that holds many floating-rate loans but desires more fixed-rate cash flows. Each bank would continue to hold and service the loans it originated, but each would achieve a more preferable cash flow structure.)

Diamond Dogs

As the above description indicates, derivatives can be tricky to explain. Although they have been around for decades, are widely used, and have many valid commercial applications, they have an undeniable image problem. In the wake of the Enron debacle, The Washington Post described derivatives as "complex, risky and largely unregulated financial contracts." The Baltimore Sun quoted Michael Greenberger, formerly an official at the Commodity Futures Trading Commission, as declaring: "Derivatives, when used speculatively, amount to nothing more than gambling." Even Linda Davies, author of the Bowie Bonds novel, argues that "derivatives are financial instruments that have no intrinsic value."

The first problem with Davies' complaint is that no goods have "intrinsic" value. The value of economic goods arises from the desire human beings have for them; it does not somehow reside in the goods themselves. Perhaps the novelist means that while stocks and bonds, for instance, are truly valuable to their owners, the value ascribed to derivatives is somehow less real. But such a complaint will not stand scrutiny.

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