Derivatives should rather be seen as economically purposeless constructs whose ease of manipulation in opaque markets makes the investment banks rich – while the rest of us take our chances.This is simply wrong. Derivatives, like all financial products, have real-world uses that benefit ordinary people and businesses. It is when they are MISUSED that the problems arise. And I would be the first to admit that in the last decade, misuse of derivatives has enriched a small minority beyond their wildest dreams and caused misery for millions.
The latest scandal concerns a form of derivative use that is close to my heart. Retail customers - small and medium-size businesses (SMEs) - have been sold derivatives ostensibly to help them manage their interest rate risk. Use of options and swaps to reduce the exposure of retail customers to movements in interest rates and exchange rates was the subject of my MBA project, and I worked in partnership with two people from the insurance industry to create what our supervisors thought would be an important new financial product. Although we did not proceed further with this ourselves, clearly the large banks have done so - or at least, they have sold derivative products to retail customers, though not quite as we intended, as I shall explain. And I am, personally, bitterly disappointed that instead of selling derivatives in the best interests of their customers, they have done so purely to make money for themselves at the expense of their customers.
I'm going to summarise here the findings of my project. It is twenty years since I completed it, and there have been many changes in banking and financial markets since then - not least the development of credit derivatives - but the salient points are still as they were then.
The main premise is that derivatives such as options (including caps and floors) and swaps have a legitimate use as INSURANCE for businesses borrowing money for investment, and, particularly, for trade. We particularly considered the need for elimination of currency risk in cross-border trade finance, for which currency swaps are useful because they combine currency and interest rate risk management (there is a relationship between exchange rates and interest rates that these swaps exploit). We also thought that currency options should be available as standalone products for businesses self-financing cross-border trade. None of this is rocket science - it is simply a case of "locking in" the future cost of financing trade flows to countries whose currencies "float" against the business's "native" currency.
For businesses financing investment by means of borrowing, there may be a need to manage interest rate risk. Business loans are often floating-rate, which means that the business's interest cost can rise considerably when interest rates rise, as historically they have done at periods of economic stress and particularly when inflation is rising. Conversely, when interest rates fall the business's interest costs also fall, which benefits them. So with floating-rate loans there is an upside and a downside interest rate risk - variable-rate mortgage holders will also be familiar with this.
Businesses that expect interest rates to rise may choose to "lock in" their interest cost by swapping their floating-rate payments for fixed rate. The product that enables this is an interest rate swap. The problem, of course, is that if interest rates then fall, the business does not benefit from the reduced interest cost. It is possible to sell on interest rate swaps that are no longer required, but when floating interest rates on lending are well below the fixed rate, the sale price will be astronomical - after all, who wants a swap that is going to make them pay MORE than they are at the moment? It is also possible to cancel them, but again that will be expensive, because the fixed rate then rebounds to the holder of the other side of the swap - who at the moment is benefiting hugely from the very low interest rates.
An alternative approach to managing interest rate risk is to cap the interest rate. This is done by purchasing a series of options that are exercised when the interest rate rises above the set limit ("strike price" of the option). The payments the buyer receives from the exercised options cover the excess interest over the agreed rate limit, effectively reducing the interest cost. I hope this makes sense (no-one ever said derivatives were easy to understand!). Interest rate caps have the advantage that they limit the risk of interest rate rises while still allowing the buyer to benefit from interest rate falls. The downside is that, just like insurance, the option premium has to be paid whether or not the options are ever exercised.
Because of their large size and diversity, multinationals are able to manage their interest rate exposure much better than SMEs. They have access to capital markets for funding and can use exchange-traded derivative products. They also are likely to have in-house expertise in financial management. But for SMEs there is no liquid market, and there may be no in-house understanding of financial management either. Most of them are reliant on bank borrowing for finance, and if they use derivatives they can only obtain them over-the-counter, because the size of the loans they are insuring is too small for exchange-traded products. Over-the-counter products are less transparent and generally more expensive - it is like the difference between bespoke tailoring and mass-market fashion. Yet for SME's, bespoke is all that is available. And they are often critically dependent on banks and accountants for financial advice - as the Breedon report noted.
My MBA project concluded that there was a clear opportunity for large banks to provide a useful service to SMEs. They could create cheap and effective insurance products to help businesses manage their interest rate and currency risk. SME lending is a mass-market product: the risks can be pooled and hedged against in aggregate. Securitisation of the loans themselves would not be necessary, because banks could hedge the lending on their own balance sheets and charge fees to the clients that were sufficient to cover the hedging costs with a reasonable margin. And we thought that banks should develop a service to advise businesses how best to use these products to control interest costs and meet foreign currency requirements.
This is very far removed from what banks have actually done. Instead of using their balance sheets and their market access to develop cheap and effective interest and exchange rate management products for SMEs, they have sold individual SMEs inappropriate over-the-counter products which they did not understand and from which they were unable to exit. Furthermore, they have made buying those products a condition of lending, and they have abjectly failed to provide the advisory service that my partners and I wanted to see. The findings of the FSA are damning:
We have found a range of poor sales practices including:
· Poor disclosure of exit costs;
· Failure to ascertain the customers' understanding of risk;
· Non advised sales straying into advice;
· "Over-hedging" (i.e. where the amounts and/or duration did not match the underlying loans); and
· Rewards and incentives being a driver of these practices.The four largest UK banks have been censured by the FSA for mis-selling, and have agreed to compensate those businesses which were sold inappropriate products (notably the notorious "structured collar", which actually increases interest cost when interest rates fall below an agreed "floor"). That's all well and good. But what worries me is that the adverse publicity around this episode, as with other episodes of derivatives abuse, will prevent the legitimate use of simple derivatives to insure against business risks. Banks won't feel able to offer them, and SME's will be too scared to accept them. This is not progress.
Many people on reading this will respond with, "Well, yes, we can see the point of simple derivatives for insurance purposes. But all this speculative trading in derivatives - that has to end. It serves no useful purpose". But they would be wrong.
You see, it is not possible to eliminate risk, only to move it. When a business eliminates the risk of adverse interest rate movements by swapping floating rate for fixed rate, someone else has to accept the risk. That "someone else" is typically a speculative trader or investor who is seeking to make a return. Similarly, with options: the writer of an option accepts the risk of adverse movement in return for a payment, in just the same way as an insurance company does - the payment is even called a "premium". But options writers are looking to make a return from accepting that risk. They are, again, speculative traders.
The job of speculative traders and investors is to make money by accepting and managing risk. If they get it wrong they can lose a LOT of money. They can even bring down a bank. But that doesn't mean that what they do is useless. On the contrary, their work is essential if ordinary businesses are to eliminate risks that don't belong to their businesses.
So let's have no more demonisation of derivatives and the people who trade them. Derivatives are useful to businesses, and the people who trade them provide a necessary service which is of value to society. It is important that this activity is properly regulated, so it remains essentially a service and doesn't become an end in itself. We should treat derivatives as what they are - insurance products - and regulate their use and their trading in exactly the same way as we do insurance.
Despite everything that has happened, and the awful reputation that derivatives (and banks) now have, I still live in hope that eventually someone, somewhere, will offer SME's the sort of cheap and effective financial risk management products and advisory service that I and my MBA partners imagined, twenty years ago.
(I apologise to Izabella Kaminska of FTAlphaville for plagiarising the title of this post. I recommend a read of her original, by the way - On the Demonisation of Debt)