In his letter to shareholders in Berkshire Hathaway’s 2002 annual report, legendary investor Warren Buffet wrote the oft-repeated phrase, “Derivatives are financial weapons of mass destruction.”
Yet just four years later, in Berkshire Hathaway’s 2006 annual report, Buffet acknowledged he had selectively used derivatives for many years and concluded, “We are likely to continue to earn – overall – significant profits from mispriced derivatives.”
More recently, the chairman of the Federal Reserve, Ben S. Bernanke, has regularly touted a public-private effort, led by the Federal Reserve Bank of New York, that removes some of the secrecy swirling around non-regulated trading of credit default swaps and other financial derivatives.
Yet one of the higher-profile proposals in this past spring’s debate over financial system reforms was one from Senator Blanche Lincoln (D-Ark.) that would mandate that all swaps – including all derivatives used by farmers, multinational companies and many investors in between – trade on an exchange.
In the wake of the contrasting waves of sentiment, what conclusions should an astute investor draw about such investments?
Ultimately, experts say such investments play an important role in the world’s financial markets. Love them or loathe them, derivatives facilitate hedging strategies, allow investors to make adjustments along the risk/reward spectrum, supply liquidity and ease diversification efforts.
“A function of derivatives is that they offer investors exposure to different asset classes and investment strategies in a cost-effective way,” says Mike Leon, a senior vice president with Northern Trust Securities Inc. “The tradeoff is that there is some added risk, but Northern Trust works to mitigate that risk through a process.”
Derivatives: An Extension of the Investable Universe
Boiled down to its simplest essence, a derivative is a financial contract that derives its value from an underlying asset, says Don Chance, a finance professor at Louisiana State University in Baton Rouge, La. When the value of the underlying security changes, so too does the value of the derivative. But because the derivative generally requires a much smaller upfront investment, the moves tend to have a much larger impact – on a percentage basis – on the returns derivatives generate.
Basic derivatives include stock options, which are securities that may cushion the blow of market downturns or boost gains; futures contracts, which offer easy access to the commodity markets without requiring the investor to take delivery of thousands of bushels of corn or tons of iron ore; and interest rate swaps, which help borrowers lock in low rates. More complex derivatives include credit default swaps, which allow institutional investors to speculate on the creditworthiness of a company or country.
“Derivatives are useful, and even Warren Buffet has warmed up to them,” Chance says. “But just like fire, chemicals and lots of other things in life, in the wrong hands or used incorrectly, derivatives can be very dangerous.”
Leon says a key differentiator between types of derivatives is the way the securities are traded. Exchange-traded derivatives are bought and sold through a central exchange that ensures both sides of the transaction meet their commitments. The clearing firm of the exchange acts as “the buyer to every seller and the seller to every buyer,” he says. It keeps daily tabs on derivatives’ market value, adjusts collateral requirements accordingly and provides full transparency to the buyer and seller.
Derivatives bought and sold in the over-the-counter (OTC) market, on the other hand, historically operated in more of a gray area. With no clearing firm serving as a middleman, the transaction was essentially an agreement between two parties. This introduced the concept of counterparty risk, which reflects the likelihood of both sides to make good on the terms of the derivative. As such, the value of an OTC derivative is as dependent upon the financial stability of both the buyer and seller as it is upon the underlying asset.
At least that’s how the OTC derivative market has operated in the past. In the coming months, the mechanics will likely change, perhaps dramatically, due to the July passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act. Under the new law, OTC derivatives are now subject to regulation by the U.S. Securities and Exchange Commission and the Commodity Futures Trading Commission.
What that means for investors is still an unknown, as specific rules and mandates are being hammered out by both agencies and may not be finalized until the fall of 2011. But ultimately, the reforms are intended to enhance the transparency and bolster the integrity of the OTC derivatives market by requiring central clearing and exchange-based trading, among other things.
A Minor Component in the Northern Trust Equation
With regard to Northern Trust clients, Leon says very few have more than a modest amount of direct exposure to derivatives – and most are of the exchange-traded variety.
Katie Nixon, a chief investment officer in Northern Trust’s Personal Financial Services division, adds that the decision to allocate a slice of a client’s portfolio to derivatives is not one taken lightly. It’s rooted in a full assessment of the client’s financial goals and objectives, including what he or she wants to avoid.
“The client may be trying to manage risk by hedging against an existing liability or position, or he or she may be looking to invest in a different asset class,” she says. “If a derivative position can help achieve that goal, we walk the client through the process to educate him or her on how the derivative is part of a broader strategy.”
Of course, the indirect exposure to derivatives is a bit of a wild card, especially in a world that has seen the notional value – or value of the assets covered by the derivative contracts – of the global OTC derivatives market explode over the past decade. According to the Bank for International Settlements (BIS), an international organization based in Switzerland that serves as the bank for the world’s central banks, the notional value of the world’s OTC derivatives market totaled $614.7 trillion at the end of 2009. That represented a nearly seven-fold jump over the $88.2 trillion in the markets at the end of 1999. Meanwhile, BIS says the notional value of exchange-traded derivatives equaled $22.7 trillion worldwide in June 2010, considerably higher than the $13.5 trillion traded at the end of 1999.
“If you’re invested in a company, you’re invested in whatever that company has invested in,” Chance says. “That’s why it’s important to protect yourself and be well-diversified so you’re not overexposed to one company or industry.”
Regulatory Changes in Flux
Since the global financial markets collapsed in 2008 and 2009, investors, elected officials and commentators have eagerly sought a scapegoat, and derivatives have been a favorite target. To be fair, mishandled bets tied to the faltering U.S. real estate market accounted for a portion of the market meltdown. But few in the financial services industry saw the logic in another Senator Lincoln proposal that would have banned banks outright from dealing in all swaps. Dodd-Frank set some limits but stopped far short of prohibiting the practice.
“It’s not the tools, it’s the person using the tools,” Chance says. “And we, as a society, certainly learned a lot about that with the recent painful market calamity.”
For its part, Northern Trust has used more exchange-traded derivatives in its risk-reduction strategies amidst the recent market environment, Leon says. The increased transparency of such investments over OTC alternatives provides improved perspectives on pricing and values while inserting a layer of certainty, courtesy of the clearing entity.
“The lack of transparency in the OTC derivatives market has been one of the key driving factors in the push to enact legislation aimed at requiring those securities to be traded on regulated platforms,” Nixon says. “Ultimately, if regulators and investors are more able to understand counterparty exposure and have more information regarding the quality of the underlying assets, this should undoubtedly allow market participants to make more informed investment decisions.”
Regardless of what the new financial industry regulations look like, and how they evolve through the rulemaking process, there’s a good chance derivatives will maintain a key role in the global markets in the coming years. All in all, that’s not a bad thing for investors worldwide.
Securities products and services are offered by Northern Trust Securities, Inc., member FINRA, SIPC, and a wholly owned subsidiary of Northern Trust Corporation.
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The foregoing discussion is general in nature, is intended for informational purposes only and is not intended to provide specific advice or recommendations for any individual or organization. Because the facts and circumstances surrounding each situation differ, you should consult your attorney, tax advisor or other professional advisor for advice on your particular situation.