Wednesday, October 19, 2011

The Real Problem: Derivatives Risk

Poof!
A financial derivative is a security whose price is derived from an underlying asset.  The derivative itself is merely a contract between two parties regarding that asset. The contract's value is determined by fluctuations in the value of the underlying asset.  The most common underlying assets include stocks, bonds, commodities, currencies, interest rates and market indexes, while futures contracts, forward contracts, options, and credit default swaps (CDS) are the most common types of derivatives of those assets.  Because derivatives are contracts which have value themselves, they can be used as the underlying asset of - you guessed it - another derivative.  Derivatives are generally used as an instrument to hedge against (lower) risk, but can also be used for speculative purposes.  For example, a European investor purchasing shares of a company on an American stock exchange must use U.S. dollars to do so, and would thus be exposed to exchange-rate risk (fluctuation) while holding that stock.  He might make 3% on the stock, but lose 3% on the currency conversion back to Euros.  To hedge this risk, the investor could purchase currency futures to lock in a specified exchange rate for the future stock sale and currency conversion.  (Read more about derivatives at: Investopedia)  The important things to remember here are: a) one underlying asset can have many derivatives, b) most derivatives are bought for very little "down", ie. they are highly leveraged to begin with, c) the derivative itself (because it has value) can be used as an underlying asset for even more derivatives which results in leveraging of the initial leverage, and d) these are private contracts with no central clearing-house (they are bought over-the-counter, OTC), and thus have virtually no visibility, let alone regulation.  And that is why, my friend, derivatives are the real risk to the global financial system, not debt.  Banks hedge their risks with derivatives from other banks called counterparties.  As long as the counterparty is fine if there is a problem with the underlying derivative or the underlying investment on which the derivative is based then there's no problem, the counterparty pays.  The problem is that derivatives don't show on balance sheets and so nobody really knows who the counterparty is, and what the solvency of the counterparty is.  They are "off balance sheet".  Now for the really bad news.  Canadian banks have assets in the hundreds of billions of dollars and this is what our government has been bragging about.  Our banks are required to maintain a capital ratio of 1 to 18, compared to 1 to 26 for US banks and a scary 1 to 61 for European banks.  That, and the fact we have a well established branch banking system that is diversified, is all on the good side.  Unfortunately they also have OTC derivative investments in the trillions of dollars and government is horrified because should we see some failures in Europe or the U.S., the banks here could suddenly be in trouble.  Hence US Treasury Secretary Timothy Geitner's pleadings with European leaders to get their act together, fast.  You aren't being told about this, or there would be a hue and cry throughout the country.  This is the real reason why so much effort was expended to save the banks in 2008: they act as counterparties to trillions of dollars of hedge funds, and the risk is cascading failures of banks and large financial institutions: the financial meltdown of financial meltdowns.

The Good News:  I forget the good part, frankly.