The key to selling the idea of derivatives to regulators and to the general public is that they are a force for good—enabling investors to hedge risk.
Different types of risk can be unbundled and sold off to different types of investors best placed to bear those risks. If, for example, you are in the export business, you can buy derivatives that offset the currency risk. Or, if you want to hedge against movements in interest rates and have taken a floating rate loan, you can swap that for a fixed interest one. What’s more—thanks to the benefits of securitization—banks and other originators of products such as mortgages can now take them out of their balance sheets, structure them and sell them on for a fat fee, while at the same time freeing up their capital to make fresh loans. In short, derivatives are supposed not to spread the risk around and therefore reduce it.
But, while the commissions are a handy source of income, the main attraction of derivatives lies in their leverage. The reason why derivatives are so popular with traders and speculators is that they require very little money to be put upfront. In India, a buyer of stocks must either put up all the money, or he can finance his purchase at a margin of 50%. If he buys single stock futures, however, the amount of money he has to put up initially is much less, on an average about 18%. The popularity of single stock futures has very little relation to hedging. An investor buying a stock may want to hedge against the risk of the market going down. He could then sell index futures. Single stock futures, however, have no such function. They are simply leveraging tools, where you can play the market by putting up a smaller amount of money. Similarly, in the mature markets, an institution can enter into a “total return swap” where the other side agrees to pay any change in the price of an index, of course at a price. Apart from the fees, there’s no upfront payment. Or a trader can buy a synthetic “note” that pays interest according to movements in a stock index and he can then pledge these notes as collateral to get back most of the cash.
Reports say that the BNP Paribas fund that went under was leveraged an astounding 17 times. Seen from this perspective, it does look as if the primary purpose of derivatives and other financial engineering products is not so much to hedge or diversify risk, as, plainly and simply, to get more bang for each buck. Using a small amount of money to boost returns is what the game is all about. As James Tobin, winner of the 1981 Nobel Prize for Economics, pointed out more than 20 years ago, “I suspect that the immense power of the computer is being harnessed to this ‘paper economy’, not to do the same transactions more economically but to balloon the quantity and variety of financial exchanges.”
But securitization and the offloading of risk via derivatives also have repercussions on the real economy. To take the example of the subprime mortgages in the US, it is only because the banks were able to slice these loans, dress them up and sell them off that they made the loans to these poor people in the first place. If they had had to carry the risk of these loans on their books, they would not have made these loans at all. However, as a result of those loans, houses were built, consumption increased and economic growth improved. By making financial assets tradable, securitization has found willing buyers for them and the increased demand for such assets has led to more loans, increasing total credit in the economy. Critics have argued that this increase of leverage in the financial system makes it more vulnerable when a downturn occurs. But it is also a way of increasing the size of markets and therefore boosting profits.
There are several ways in which markets can expand. One is to sell to hitherto closed markets, such as India and China. Another is to produce goods and services more cheaply, by higher productivity or shifting production to low-cost countries (globalization). Sectors that used to be closed to the private sector—such as utilities or infrastructure or education and health—could be thrown open, which again expands the scope for profits. And finally, higher levels of consumer debt lead to a widening of markets as consumers use financing to make tomorrow’s purchases today.
In the US, for instance, a recent report says that the average income in 2005 was lower than the average income in 2000, and that nearly half of all Americans reported income of less than $30,000 (Rs12.3 trillion) in 2005. How do you turn such people into home-buyers? By a combination of debt and derivatives. That is the reason why central banks are so reluctant to see the bubbles pop.
After the collapse of Long-Term Capital Management (LTCM), the US set up a president’s working group on financial markets, which included Robert Rubin and Alan Greenspan, to probe the reasons for the debacle. In its report, the group said, “While leverage can play a positive role in our financial system, problems can arise when financial institutions go too far in extending credit to their customers and counterparties. The near collapse of LTCM illustrates the need for all participants in our financial system to face constraints on the amount of leverage they assume.”
Eight years later, in spite of much higher leverage in the system, that recommendation is yet to be implemented.
Mint’s resident market expert Manas Chakravarty looks at trends and issues related to investing in general and Indian bourses in particular. Your comments are welcome at firstname.lastname@example.org.