Derivatives Debacles

Article excerpt

Recent years have witnessed numerous accounts of derivatives-related losses on the part of established and reputable firms. These episodes have precipitated concern, and even alarm, over the recent rapid growth of derivatives markets and the dangers posed by the widespread use of such instruments.

What lessons do these events hold for policymakers? Do they indicate the need for stricter government supervision of derivatives markets, or for new laws and regulations to limit the use of these instruments? A better understanding of the events surrounding recent derivatives debacles can help to answer such questions.

This article presents accounts of two of the costliest and most highly publicized derivatives-related losses to date. The episodes examined involve the firms of Metallgesellschaft AG and Barings PLC. Each account begins with a review of the events leading to the derivatives-related loss in question, followed by an analysis of the factors responsible for the debacle. Both incidents raise a number of public policy questions: Can government intervention stop such incidents from happening again? Is it appropriate for the government even to try? And if so, what reforms are indicated? These issues are addressed at the end of each case study, where the lessons and public policy concerns highlighted by each episode are discussed.

1. RISK AND REGULATION IN DERIVATIVES MARKETS

Perhaps the most widely cited report on the risks associated with derivatives was published in 1993 by the Group of Thirty -- a group consisting of prominent members of the international financial community and noted academics. The report identified four basic kinds of risks associated with the use of derivatives.(1) Market risk is defined as the risk to earnings from adverse movements in market prices. Press accounts of derivatives-related losses have tended to emphasize market risk; but the incidents examined in this article illustrate the importance of operational risk -- the risk of losses occurring as a result of inadequate systems and control, human error, or management failure.

Counterparty credit risk is the risk that a party to a derivative contract will fail to perform on its obligation. Exposure to counterparty credit risk is determined by the cost of replacing a contract if a counterparty (as a party to a derivatives contract is known) were to default.

Legal risk is the risk of loss because a contract is found not to be legally enforceable. Derivatives are legal contracts. Like any other contract, they require a legal infrastructure to provide for the resolution of conflicts and the enforcement of contract provisions. Legal risk is a prime public policy concern, since it can interfere with the orderly functioning of markets.

These risks are not unique to derivative instruments. They are the same types of risks involved in more traditional types of financial intermediation, such as banking and securities underwriting. Legal risk does pose special problems for derivatives markets, however. The novelty of many derivatives makes them susceptible to legal risk because of the uncertainty that exists over the applicability of existing laws and regulations to such contracts.

Although the risks associated with derivatives are much the same as those in other areas of finance, there nonetheless seems to be a popular perception that the rapid growth of derivatives trading in recent years poses special problems for financial markets. Most of these concerns have centered on the growth of the over-the-counter (OTC) derivatives market. As Stoll (1995) notes, concern about the growth of OTC derivatives markets has arisen because these instruments are nonstandard contracts, without secondary trading and with limited public price information. Moreover, OTC markets lack some of the financial safeguards used by futures and options exchanges, such as margining systems and the daily marking to market of contracts, designed to ensure that all market participants settle any losses promptly. …