Sunday, 1 July 2012

On the demonisation of derivatives

Ever since the financial crisis of 2007, there has been a prevalent belief that derivative financial products - swaps, options and the like - are a) useless and b) harmful. So, for example, in today's Guardian, Will Hutton castigates derivatives:
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)


  1. Frances

    This is very interesting. I looked into something similar about 20 years ago when I was working for a large accountancy firm, as a tax adviser to SMEs and small Plcs, and I came to much the same conclusion (from a non random sample.)

    All that was needed really were interest rate caps and fixed exchange rates, but often the premium was expensive, or the Finance team did not fully understand how the contracts worked.

    Simple derivatives were seen as only ever a cost, as the benefit is only notional eg you don't pay higher rates, and there was no obvious impact on P&L. To that extent it is just like insurance, which to my mind is the only way to look at it.

    From memory, fixing exchange rates for example means that you can miss out on any upside, and some businesses preferred to take the gamble.

    1. Interest rate caps are good products for SMEs, and I note that the FSA has excluded them from the list of products available for redress due to mis-selling.

      Fixed exchange rates (FX futures) are not always a good idea, because as you say the customer can't benefit from advantageous movements. We preferred currency options - the premiums were usually small (they may be higher now, of course) and it meant the customer retained the upside benefit.

  2. Producers very often desire to rid themselves of uncertainty about future price movements. Removing uncertainty helps producers to plan and to budget and to guarantee profits. They are prepared to pay for certainty.

    Speculators seek risk and hope to make a profit from it. By taking on risk they can remove the uncertainty that producers wish to avoid. Derivatives bring the two parties together for each other's mutual benefit. By entering into a derivatives contract the hedger lays off most of the uncertainty which is taken up by a speculator. Both parties get what they want. What's not to like?

    Also, there is probably a public interest benefit too as commodity price instability is reduced because of hedging. This benefits final consumers (eg in their weekly shopping basket).

    Clearly, derivative products such as Futures, Options and Swaps can be very useful and impact favourably on the real economy. Markets that facilitate the bringing together of hedgers and speculators are a good thing and are socially useful. It's hard to see why anyone should be opposed to them.

    It's very disappointing to see Will Hutton (of all people) displaying ignorance about the topic.

  3. I'm wading in somewhat outside my area of expertise here...

    The mis-selling scandal is not really a derivatives scandal. It's a mis-selling scandal that relates to derivatives. So whilst derivatives feature, they're not really the problem - the mis-selling is.

    The suspicion relating to derivatives comes from the banking crisis itself, where (in brief) they bet big on a rising property market and took on risks they couldn't stand behind.

    A few things spring to mind:

    - there's a difference between hedging risk and maximising risk for profit
    - securitisation may often have less to do with hedging risk of future failure and more to do with getting quick capital to make more financial bets
    - extra liquidity (as provided by securitisation) is only economically useful if it is invested into economic ends that have some kind of wider economic use (i.e. the 'real economy')
    - there is a difference between simple derivatives of the kind you describe here, and highly complex derivatives where the risks and potential costs are opaque
    - there is a difference between the counter-party to a derivative, who is taking on the immediate risk for profit, and those who trade complex derivatives based on derivatives or repackaged assets, where the risks are barely understood - which are the real speculative trades
    - short selling can wreak at least as much havoc as the worst derivatives trading, and has much less social or economic use
    - part of the opposition to derivatives is simply based on the idea that this is 'funny money' and 'unearned wealth'

    In other words, and I'm obviously over-simplifying, there are 'good' derivatives and 'bad' derivatives.

    I tend to think that in finance, you can either regulate the asset itself, regulate the market by which the asset is traded, or regulate the parties trading the asset. Different approaches work in different scenarios.

    The trouble is these markets have grown exponentially with nobody stopping to drill down and ask what the different kinds of derivatives and assets are, what the risks are for each, and what the roles of the different kinds of trade might be. There might be parties that should be heavily restricted in what risk they take on via derivatives (e.g. retail banks). There might be some forms of derivatives that should be banned, or some forms of assets where derivatives should be restricted. But the point is - not all derivatives trading has a socially or economically useful purpose, any more than none of it has.

    So that's where I'd guess things have to go from here - greater clarity on which kind of derivatives trades should be encouraged, which should be restricted or controlled, and who should be able to dabble in how much of it.

    Needless to say, I'm in no position to provide any such clarity myself...


  4. "Needless to say, I'm in no position to provide any such clarity myself..."

    Beyond saying that simpler is better, and more complex... isn't.

  5. I don't understand how a CFO can claim to have been mis-sold a product like a structured collar.

    If you sign a contract and don't understand the terms, then you have clearly not fulfilled your fiduciary duty and that really is a scandal.

    No doubt if rates were at 10% every cfo that had put a collar on would be taking all the credit.

    1. These are SMEs. What makes you think there are CFOs? One of the big problems is that SMEs are often seriously lacking in in-house financial expertise and dependent on outside advisers. Their accountants also may be lacking expertise in anything other than how to produce a set of statutory accounts. So SME owner/managers often trust banks for financial advice - and if those banks use that trust as an opportunity to sell them products that aren't suitable, that is mis-selling.

      Banks are now banned from selling structured collars to SMEs and must compensate any SME that has been sold a collar. That's in the FSA report. However, simpler derivatives are to be dealt with on a case-by-case basis, and interest rate caps are excluded from the findings completely.

      There have been examples in the media of SME owner/managers complaining that the interest rate product they were sold prevented them taking advantage of current low interest rates. Peston did an entire article about one of them, without apparently noticing that the whole point of the product was to fix the interest rate and that losing benefit of low rates was therefore a consequence. Arguably they should have been sold a cap not a swap, but that may not actually have been mis-selling so much as misunderstanding. There will be a lot of SME owner/managers jumping on this bandwagon and claiming mis-selling when the bank may have acted reasonably.

    2. I don't agree with this idea; the regulator should not be there to act as the nanny. I doubt many SME such as a butcher's shop would say that they have expertise in fridge manufacturing, yet if they bought a fridge that was too expensive, or kept things below a temperature they wanted under the advice of fridge salesman, they would not expect to get compensation, especially if the product fulfilled the stated function.

      From some of the comments above, I think an interesting question for people to consider is whether a market should serve a social function?

    3. @BlackRaven

      Not sure what you mean by the phrase "social function" but I am sure that markets should work in the public interest.

  6. I agree that derivatives are not inherently bad.

    But I'm not convinced by the argument that SMEs paying floating rates should buy caps rather than trade swaps, so as to retain the upside should the interest rate fall. If the SME had borrowed at a fixed rate in the first place, would you advise it to buy an interest rate floor, so as to get the same upside?

    Hedging with options rather than swaps and forwards is a good idea if you're uncertain of the size you need to hedge, for example if you're exposed to FX risk on future trades but you don't know how much you'll be trading.

    I'd also quibble with the claim that "it is not possible to eliminate risk, only to move it". Option valuation theory is based on the idea that the risk in an option can be eliminated by dynamic hedging. The theory is only an approximation: the risk can't really be eliminated, but it can be reduced if you are in a position to execute the hedging strategy, which is a good reason for the risk to be held by a bank not an SME.

    1. Hi Paul,

      Yes, actually I might advise an interest rate floor in that case. But it really depends on your view of the likely direction of interest rates, so it's still a gamble - if interest rates move up over the lifetime of the loan, the option premium is wasted. But heigh-ho, that's how insurance works.

      I think whether you prefer options or swaps depends partly on the circumstances and partly on personal preference. I am personally more comfortable with options than swaps - though that might be because I've spent more of my life working with them. The point is though that ALL of these products should be viewed as forms of insurance.

      Yes, someone else picked me up on that. I know option pricing is done on the basis of risk neutrality, but I don't think it's strictly correct to regard hedging as "eliminating" risk. I prefer to regard it as "neutralising" risk. Risk is partly or completely neutralised by the existence of an offsetting position, but if one of the positions unwinds, hey presto your risk is back again. Hedging requires active management.

      I have actually seen an OTC FX options desk lose a lot of money because it had priced its options on the assumption of full hedging then failed to hedge the underlying. This little incident was the reason for my first visit to NatWest.

    2. I'm not surprised. Many option traders treat dynamic hedging as an opportunity to make money by "market timing", i.e. by taking directional punts.

  7. You agree that speculation is key to move risk to others. But as the one who speculates is a bank that if it goes wrong simply asks for a bail out (let tax payers pay) I'm not so sure it's a good thing.
    Speculation is always risky (it's part of the definition) and is fine if you do it with your own money but not with tax payers money!