Jumping blind into the futures: Few understand financial derivatives

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HAVING thoroughly digested the Group of 30's report on its landmark study of financial derivatives, I now agree with the practitioners that this is not a game for 'the little people'. Only the big fish are going to survive in this dollars 5,000bn pond.

The US magazine Business Week has identified derivatives as a key component of the new global 'casino' society, characterised by trillions of dollars of debt sloshing around the world through invisible channels. Felix Rohatyn, the New York investment banker, is credited with the remark that derivatives are financial hydrogen bombs built by 26-year-old MBAs on personal computers. The G30 report was supposed to allay such fears but I, for one, am not convinced.

Brian Quinn, the veteran Bank of England regulator, is another doubter. At a recent G30 seminar in Washington during the annual meetings of the International Monetary Fund and the World Bank, he warned against ignoring the potential systemic risk posed by largely unregulated financial derivatives. As long as there are no capital adequacy standards or other international requirements, no one can be sanguine about the risk.

Paul Volcker, the G30 chairman, alluded to these off-banking sheet risks by noting that the study's authors clearly concluded that the amount of capital necessary to support derivative exposure was a matter 'of judgement for individual institutions'. In other words, regulators should not step in where sound financial minds do not fear to tread.

A significant contribution of the G30 report is its clear explanation of the technically abstruse world of derivative trading. It is a report that only professionals and end-users could have compiled. Privately, central bankers and other international regulators concede that they simply do not have the resources or in-house expertise to do something similar. For the moment, the world's taxpayers are dependent on the industry's word.

The G30 study, which lays out a system of risk management that is essentially self-administered, is the industry's attempt to minimise government interference. The uninitiated are introduced to a world of swaps, options, futures, caps, floors, collars, swaptions and other privately negotiated contracts offered internationally. The value of these new instruments derives from a broad range of 'underlyings' - equities, commodities, interest rates, exchange rates and so on. The way they are packaged, however, is mind-boggling.

Much like customised cars, derivatives can be constructed to satisfy the user. From a base of forward-looking transactions and options, they are built into a myriad of different structures, all in the name of lowering costs and managing risk. The big question, of course, is how many people actually understand the end exposure of these brilliantly built financial instruments.

Even the report concedes, for example, that there are complex risks inherent in options-based derivatives. The valuation of these is based on a series of theories and mathematical models built in the 1970s. After reading the five factors that are crunched into a computer to determine the value of options, one can only wonder where the 'reality check' based on real world conditions comes in.

The G30 report stresses that senior managers must be directly involved in assessing derivative activity. But there is no guarantee they will be up to the task. For example, the report notes that senior management is worried about its own lack of understanding and over-reliance on specialists. Considering the bad decisions that have been taken in other areas - junk bonds, savings and loans, real estate debt - this is not comforting.

End-users of derivatives include most large multinationals, huge institutions such as the World Bank and, more recently, sovereign nations, which have turned to currency swaps to manage their debt and to commodity derivatives to manage oil price risk. Again, little people like myself, remembering the developing world debt crisis of the early 1980s, get very nervous at such exposure. Derivatives are not always going to produce 'win-win' situations, as much of this report implies.

The bottom line of the G30 report is that the industry must adopt strong in- house standards to minimise risk, and that international regulators must take certain minimal accounting, tax and other steps to fill in gaps. However, I shall feel a lot better when the world's central banks finance their own equally comprehensive study and produce more objective conclusions.