Fear of Derivatives - Followup

I found the article below on the web recently and wanted to respond to it, however the author does not allow comments on his blog:

Fear and Loathing - WMD or "What are Derivatives?"

The article is an edited extract from the book: Traders Guns and Money: Knowns and Unknowns in the Dazzling World of Derivatives by Satyajit Das. It is precisely the sort of article that I had in mind when I wrote my earlier article on derivatives. It attempts to instill fear in the mind of the reader without actually addressing the real issue of derivatives.

He talks in a Rumsfeldian (not a compliment) manner about "known unknowns" and "unknown unknowns" in the area of derivatives, and makes the case that unknown unknowns are a cause of obvious concern. He then name drops a complicated sounding financial product "double knockout currency option with rebate" and presents it as a known unknown.

Obviously, yes, most lay readers of his book don't know what such an instrument is, however to portray it as an unknown in the context of financial markets is ridiculous. Anyone involved with such instruments knows what they are and why they are used (I may discuss it in another post), and they are certainly not an unknown of any sort.

His article therefore appears to be attempting to instill in the reader a sense of fear in derivatives, based on their own lack of knowledge. He also goes on to state that the only driving forces behind the use of derivatives are fear and greed. I don't intend to discuss the actual uses for derivatives in this article but suffice to say, you wouldn't see a 400+ trillion USD market for them if their use was only motivated by such irrational emotions.

As for the motivation of the author for writing such an article, I can only assume that at least one of those emotions was his driving force - and he seeks to sell more copies of the book based on the back of it.

Should We Be Scared of Derivatives

I've seen a number of articles on the net over the last few months or so where the authors appear to have a fear of the derivatives markets for a few ill considered reasons. I want to take a bit of time to allay those fears and discuss the markets in a bit more detail.

There seem to be a number of areas for concern, and I want to discuss each in turn. The first problem seems to be with the sheer volume of derivatives trading that takes place. People see the headline figures and think the numbers are so crazy as to be unsustainable or unmanageable. One example is that the total size of outstanding contracts in oil derivatives can be larger than the total amount of oil in the ground. Actually this is not such a surprise due to the concept of "Notional Value" in derivatives contracts. This means that when someone uses a derivative to gamble on the future price of oil, they can "up their stake" by increasing the hypothetical amount of oil that they want to gamble with. If things don't go their way, they pay the counter party the cash amount that was lost in the bet, rather than supplying some oil at a favourable cash value - no physical delivery means there is no dependence on the black stuff in the ground. This leads us to the idea that contracts are "Cash Settled"; that means physical delivery is in the vast majority of cases not performed, so therefore the amount of oil in the ground is not relevant. What actually happens is hypothetical amounts of oil are used as the basis for betting on future prices - either as a means of speculation or to hedge risk (this risk hedging is common in the airline industry for example).

A second worry seems to be with managing risk, with such large numbers going around, its easy to think that if someone defaulted somewhere in the system, the knock on effects could be disastrous. However this problem can be controlled in a number of ways - first of all is
"Margining", which means a trader has to front money (the "margin") to an exchange before being allowed to trade. If a position starts to go badly, the exchange will pocket money from
the margin account until it falls to a certain, minimal level. At this point the exchange makes a "margin call", whereby the trader has to refund his margin account or the position gets closed. In this way, an exchange will never be out of pocket, because they have the right to close positions that do not have sufficient margin to cover the hypothetical losses for a few bad days trading.

Another point is the lengths that banks have to go to when covering the money they have at risk. The regulatory authorities (FSA in the UK and SEC in the US) enforce certain rules about how much money banks have to keep readily available to pay off potential future losses. This is often done based on an analysis of their current investment portfolios and a statistical likelihood of the future value. From this it is possible to say, "We're 95% sure that we won't lose more than 100M USD in the next 10 days". The regulators will take that value, multiply it by maybe 3 or 4 depending on the model used to calculate it, and then ensure that that value (300 or 400M USD) is kept in reserve for unexpected heavy losses. The calculations are performed on a daily basis and monitored by the regulators very closely - so the dangers of catastrophic loss are virtually eliminated.