In Defense of Derivatives

Derivatives and Risk have become synonymous in the lexicon of Main Street, especially so since August 2007. A number of fallacies have been bandied about. Fallacy 1: Derivatives are the culprits of the current liquidity crisis. Fallacy 2: Derivatives are Risk. Fallacy 3: Derivatives are Wall Street alchemy.
To right fallacies 2 and 3, derivatives are neither “risk” nor are they “Wall Street alchemy”. Derivatives are a technology. The technology of derivatives is ultimately about risk management. Derivatives Technology slices and dices risk into different components and parcels it off to different trading parties, to those who want to take on the specific risk component(s)—i.e. the buyers of risk or investors in risk—which ultimately means that there are those who want to lay off the [same] risk component(s)—i.e. the sellers of risk. Derivatives technology is about the management of risk, the spreading of different components of risk to different parties who want to take it on. How is this risk transferred to market participants? Obviously, like any other market, at “market-clearing” prices. There are bid and offer prices for the specific risk component and the risk is sold/bought at market-clearing prices.
At this point you may be asking who the risk sellers/originators are and who the risk buyers/investors are. Risk originators are the banks, the investment banks, thrift institutions, finance companies, mortgage banks, etc. Risk buyers are the proprietary trading desks of banks and investment banks, hedge funds, insurance companies, pension funds, etc.
A “market for risk”, where different risk components are bought and sold, was then created with the advent of derivatives technology. The spreading of risk(s) throughout the financial system was and is responsible for the growth of this system and the concurrent underlying economies. Indeed, the exponential growth of credit—first in the form of mortgages and then in the form of all types and variants of credit— is one of the by-products of derivatives technology.
So, what is going on now? Why are we seeing the meltdown that started in August? Is Fallacy 1 indeed not a fallacy? Are derivatives indeed the culprits of the current liquidity crisis? If derivatives technology is a risk transfer mechanism responsible for orderly spreading of risk among market participants and, as a result, responsible for the growth of our economies, then why do we have a crisis on our hands?
What has failed us is not derivatives technology. Our current liquidity crisis is the result of lax origination and investment guidelines, lax credit and market risk management and lax rating standards in an era of unprecedented liquidity.
We have been so awash in liquidity in the past several years that returns on assets have compressed to historically low levels as investors chase assets with attractive returns. This in turn led to those who package/sell risk to originate and sell off riskier risk so as to bump up returns to levels that risk buyers seek—an attempt to structure and price risk at then market-clearing prices. The classic forces of demand and supply were in the works as risk originators/sellers went further down the credit spectrum originating assets with higher return [and higher risk] in response to demand by the buyers/investors in risk demanding more attractive yield. Due diligence of these underlying assets was lax by both risk originators/sellers and risk investors/buyers in the quest for higher returns in an era of high liquidity. Enter the rating agencies. Ratings given by rating agencies are important elements in the due diligence carried out by investors. The rating agencies assigned their ratings to new structures and let investors down in their fiduciary responsibility of monitoring the risks of these securities and downgrading them in a timely manner, namely before a market collapse not after.
If rating agencies were lax in rating standards and risk monitoring and if risk originators and risk investors were lax in due diligence, what happened to the credit and market risk management functions at the sellers and the buyers of risk, the ultimate backstops. Credit departments have to approve any transaction that gets on the books with credit/counterparty risk exposure. Furthermore, while credit departments are responsible for portfolio monitoring of credit risk as long as any deal remains on the books, the market risk group is responsible for the daily valuation and daily analysis of the risk of every deal on the books. Wall Street quants assert that derivatives pricing is a science with highly sophisticated mathematical models as underpinning. Having been a quant myself prior to moving over to origination and structuring of derivatives, I would beg to differ. Yes, we do use highly sophisticated mathematical models for pricing derivatives. And, in most cases these models work. These are cases where markets are “normal”, functioning smoothly and thereby “mark-to-model” pricing is equivalent to “mark-to-market” pricing. These models, however, do not work in times of market crises when liquidity dries up—“mark-to-model” pricing diverges widely from “mark-to-market” pricing in a liquidity crisis. And it is in these times that derivatives pricing and risk management becomes an art and not a science as witnessed time and time again, most recently in the past several months and prior to our current crisis in the Long Term Capital Management crisis when liquidity dried up.
Credit and market risk management are an art in both the best of times and the worst of times. Indeed, prudent containment of risk requires the application of the art to the science continually, in good times as well as in bad times, such that when the bad times come, as they surely will, the fallout is not so spectacular as to create a crisis.

Dangers of the Dollar's Freefall

The US dollar's plunge is ultimately dangerous not only to our economic well-being but also to our currency's standing as the most important global reserve currency. That the freefall is permitted is at best irresponsible.

The dollar is the world's most important reserve currency. With such large erosion in its value, the dollar runs the risk of being dumped by the central banks of the world as they shift their reserve composition towards the euro and dispose of dollars. China's central bank, which has one of the largest reserves in the world, last week announced just such a potentiality. If China and other countries undertake such a measure, the dollar's freefall will only be accelerated and exacerbated.

We are seeing oil prices hovering at near $100 levels. One of the main trendline reasons for this current spike in oil price is the decline in the value of the dollar. Price of oil is denominated in dollars. The lower the dollar goes, the higher goes the price of oil. As oil producers see a decline in the value of their production because of the decline of the dollar-- i.e. their revenues have lower purchasing power-- they drive up the price of oil to compensate for their purchasing power erosion arising from the dollar's decline. This pendulum will continue as long as the dollar falls further. The ultimate impact of high oil prices and low-value dollar on our economy and that of the world's is recessionary.

That our policymakers have allowed this freefall is irresponsible both domestically and internationally. Concerted intervention in foreign exchange markets together with concerted interest rate policy setting by central banks needs to be undertaken to stem and reverse the freefall and prevent global recession.