On the evening of February 23, 1995, Nick Leeson, a Singapore-based trader for British bank Barings, boarded a plane to Kuala Lumpur, Malaysia in the hopes of escaping prosecution in Singapore for committing fraud against his employer. For some time, Leeson had been using financial derivatives to make enormously leveraged bets on the direction of the Japanese stock market and Japanese interest rates. When an earthquake in Kobe, Japan threatened Leeson’s trades, he doubled down on his previous bets in anticipation of a market reversal that never materialized. Leeson ultimately served jail time and Barings Bank, among the most celebrated and historic banks in the world, went bankrupt. The chairman of Barings Bank had previously noted, at the launch of a 1993 joint venture in derivatives, “Derivatives need to be well controlled and understood, but we believe we do that here.”[i]
Contemporaneous with the collapse of Barings Bank, a new kind of financial product, called a credit default swap, was invented in New York City by employees of JP Morgan & Co. This new product allowed for the purchase and sale of insurance policies that paid out upon the default of a third party. The largest insurer in the world, American International Group, became enthusiastic sellers of the product, ensuring the company steady earnings streams so long as credit defaults were rare. Should defaults occur, however, on the debt in which American International Group had sold credit default swaps, the company was liable to its counterparties just as an insurer of homes is liable to its policyholders should a fire destroy their homes. But unlike many traditional insurance lines in which the probabilities of losses on multiple policies are often independent of each other, credit default chances of two entities are not independent of each other at all, meaning that an economic downturn could systematically increase the chances of American International Group losing money on all of the policies they had written. That downturn arrived in 2008. Were it not for extraordinary assistance from the Federal Reserve System, American International Group would have certainly gone bankrupt and potentially set off cascading bankruptcies from the insurance giant’s counterparties, which included Société Générale, Goldman Sachs, and Deutsche Bank. One American International Group executive famously said of credit default swaps, “It is hard for us, without being flippant, to even see a scenario within any kind of realm of reason that would see us losing one dollar in any of those transactions.”[ii]
The ability to crush large corporations seemingly overnight and to destroy confidence in the financial system has made various forms of financial derivatives a primary concern of regulators.[iii] Derivative contracts are a somewhat broad class of financial instruments linked by the fact that the value of the contract “derives” its value from a separate event or security price that could include a future foreign exchange rate, level of interest rates, equity price or equity index level, commodity price, or credit default.
An example would be a company that must purchase a large amount of an underlying commodity, perhaps cotton, and that wishes to hedge its risk against future increases in cotton prices. That company could agree to a contract with a bank or cotton producer that gives the company the future right to purchase a set amount of cotton on a certain date at a fixed price in exchange for a premium. If cotton prices fall, the company simply does not exercise the option and suffers a loss only on the premium that was paid. If cotton prices increase, the counter party to the contract must provide the company with cotton at a lower price than it would have otherwise been able to secure in the market. While hedging activities such as this one are not often a serious concern of regulators, these same products can be used by traders or banks to seek risk by booking short-term profits at the expense of longer term liabilities. They have also been shown to amplify the underlying risks present in the financial system and global economy.
While there is not intent to make sweeping normative arguments concerning the role of derivatives in the financial system, this article will examine the historical foundations of today’s derivatives markets and focus on the consistently complex relationship between regulators and these instruments. This will be done in three sections: a brief history of the development of these products, a discussion of why derivatives can present asymmetric risk to financial stability, and a review of the regulatory responses to derivatives within the United States as well as potential policy prescriptions.
It is generally agreed that contracts that could be classified as derivatives grew out of the agricultural societies of Mesopotamia sometime around the second millennium before Christ’s birth.[iv] The uncertainties surrounding an agricultural livelihood almost guarantee the creation, at some point, of futures contracts. Futures contracts help both the buyer and seller of a commodity reduce risk by locking in a future price.
Derivatives have also played key roles in the development of international trade. Bills of exchange, a type of negotiable instrument, became prominent in coastal European cities by the Renaissance and promised the future delivery of foreign currency in a different location. As cities such as Antwerp became centers of this burgeoning trade, cash-settled options were developed. These options were contracts based on underlying assets but were settled for the cash values of the underlying assets rather than by forcing the procurement of the physical commodity.
Once cash-settled options became commonplace, a feature of derivatives became readily apparent to traders: one could use derivative contracts as a means to dramatically increase leverage without actually employing debt. One consequential example of this can be found in the famous phase of “Tulipmania” in the Netherlands during the 1630s. Tulips, native to Turkey, were brought to Amsterdam, where they quickly became popular. Speculative traders, who could ordinarily not afford to purchase large numbers of tulip bulbs, were able to bet on future price increases in tulips without owning the underlying asset or even having the necessary capital to purchase the underlying asset since the only cash trading hands was the value of the option itself. Of course, that kind of leverage could leave the speculator with nothing if the trade went against him, which is precisely what happened after tulip prices crashed in 1637.[v]
Given the ancient history of derivatives, their importance in the financing of trade flows, and their contribution to the creation of financial markets out of sync with broader reality, why do so many people today view derivatives as a modern invention that has either wreaked havoc upon or ensured sophisticated risk management techniques (depending on your perspective) since the 1980s?
One possible answer is that there has genuinely been a large degree of innovation within derivatives, primarily within the United States. Among the most meaningful was the development of an option pricing model in 1973 by Fischer Black and Myron Scholes[vi]. Their model not only made options pricing easier and more transparent, it also set off a wave of ever more complex mathematics being employed in the finance sector along with the rise of financial engineering. Concurrent with the development of the underlying models was the rise of computing power to execute strategies derived by the models themselves. Without more powerful means of computation, models such as the Black-Scholes model of options pricing would never have been practical since probability distributions are incredibly tedious to compute by hand.[vii] Also in 1973, the Chicago Board of Options Exchange (CBOE) was launched to trade and clear these options.
As institutions and traders embraced more esoteric products, their power was also seen within large financial institutions. Just as various financial derivatives were introduced into the mainstream, large investment banks were losing a prime source of revenue: equity commissions. On May 1, 1975, a new rule promulgated by the Securities and Exchange Commission abolished fixed commissions.[viii] According to a 2002 Columbia Business School study[ix], the average commission rate for trades placed on the New York Stock Exchange stayed fairly consistent from the time of the Great Depression until the middle 1970s, at a cost of about 1% of the transaction. At the time of the study in 2002, that cost was only one-fifth that size, at 20 bps.
Trading equities on exchanges had always been an undifferentiated business, and the removal of protective regulation stripped that business of most of its profits. Investment banks were forced to turn to less differentiated products and market-making activities in the FICC (Fixed Income, Currencies, and Commodities) space as well as derivative products[x]. Throughout the 1980s and 1990s, innovation in financial derivatives continued at a breathtaking pace among large banks, primarily in the United States, including the creation of the credit default swap in 1994.[xi]
With Western Europe and Japan fully recovered from the Second World War, and with the subsequent fall of the Soviet Union and the rise of Asian market economies, multinational corporations became the dominant form of large company by the 1980s and 1990s. Multinational companies drove the need for more sophisticated risk management techniques than single-country corporations would have demanded, including the means to hedge exposure to various interest rates around the world in addition to currency fluctuations and raw material costs[xii]. In addition, in a departure from the original reason why derivatives were created, many investors and fund managers began using derivatives for risk-seeking and not hedging activities.
Several commentators have illuminated the ancient history of financial derivatives and expressed surprise that many seem to hold onto a belief that derivatives are a new invention rather than a set of very old products stemming from civilization’s agricultural roots. While they are undoubtedly correct, beginning in the 1970s genuine shifts took place that would have a monumental impact on the global financial system and global economy. More complex mathematics coupled with advancing computing technology allowed for the introduction of large-scale derivative trading; investment banks needing to replace lucrative equities trading caused a strong desire among the suppliers of financial instruments to see widespread use of derivatives; and both risk-hedging and risk-seeking institutions ensured that demand for these instruments grew at an astonishing pace.
The great irony at the heart of derivatives markets is that products ostensibly designed to mitigate specific financial risks can also be used to exponentially increase the risk inherent in the portfolios of both buyers and sellers. They also made irrelevant a substantial number of Depression-era financial regulations intended to ensure stability in the financial system.
Margin requirements are a very good example of the irrelevancy of formerly pertinent regulation. Leading up to the 1929 stock market crash, a significant number of unsophisticated investors borrowed heavily in the hopes of getting rich from stock market investing. Obviously, by the rules of arithmetic, they could lose everything they invested if a very small move was made in the underlying value of the securities. Margin requirements were subsequently introduced and aimed at preventing this kind of loss in addition to reducing overall market volatility from enormous swings in participant leverage.[xiii] For many years now the margin requirement has been set at 50% by the Federal Reserve for long equity positions, meaning all broker-dealers are required to make margin calls if a customer’s equity in an account falls below 50% of the overall value. In practice, then, an equity account could not be maintained with a leverage ratio in excess of two to one.
Now consider the leverage inherent in many derivative contracts using total return swaps as an example, an instrument in which one party receives a fixed rate and another receives the return of an underlying asset. If, hypothetically, one party receives the current LIBOR rate and the other party receives the total return of an equity index, the returns of the swap for the party receiving the return of the equity index would mirror the proceeds from buying the index on margin at short-term interest rates. However, in this instance, the parties do not need to invest the principal capital. If a $10 million contract were to be written in the hypothetical scenario above and the equity index were to rise 10% while LIBOR averaged 3% over the period, the investor receiving the index return would net $700,000 but not be required to invest the $10 million as they would have been required to do if they had sought the same return through a margin account. Indeed, the power of derivatives is due in part to their ability to allow investors to own nothing more than the volatility of an underlying asset.
With complicated formulas and algorithms, derivatives also give false precision to their traders.[xiv] For example, the Black-Scholes model previously mentioned for pricing options closely approximates the fair value of a short-term option but struggles to adequately value longer dated options – meaning that trading them requires some common sense in addition to different modeling assumptions.
The false precision of derivatives and the nearly unlimited amount of leverage they provide is best seen in the 1998 collapse of hedge fund Long-Term Capital Management (LTCM) – a fund in which Myron Scholes was a principal. The fund used derivatives extensively to make leveraged bets on the convergence of asset prices to historical norms and was made insolvent by the Asian financial crisis and the 1998 sovereign debt default by Russia.[xv]
Derivatives can present asymmetric risk even when they are used solely for risk management purposes because they have the ability to concentrate risk that had once been diffused. In 2015, the five largest holders of derivative contracts in the United States accounted for 94% of the total notional value of derivative contracts in the country.[xvi] These banks also routinely trade and transact with each other, amplifying the wreckage should any one of them suffer huge losses on positions.
Derivatives can present substantial counterparty risk as well[xvii]. Trading most financial instruments does not pose this same sort of risk because the transaction is settled in a short period of time. Because derivative contracts can expire many years into the future, counterparty risk on contracts can be similar to the default risk of lending money. This risk is assuaged somewhat by the practice of “netting,” where collateral must be posted by both parties over time as the value of the contract fluctuates. Centrally cleared derivatives, as opposed to bilateral contracts, can also help mitigate counterparty risk by making the clearing agent the counterparty of the trade to both the seller and buyer of the contract.[xviii]
A final avenue of systemic risk from derivatives concerns appropriate accounting. Derivatives are frequently accounted for on a mark-to-market basis with unrealized profits and losses flowing to a company’s income statement over time. The challenge is that no two people are likely to record identical values for a specific contract even if they use the identical valuation model because of different estimates of future interest rates, asset volatility, and other variables. Derivatives are routinely booked in company accounts as profitable to both parties at inception – something that cannot be true in the zero sum game of the instruments. Flawed accounting can create inappropriate assessments of the health of an institution by the company itself, regulators, and investors.[xix]
The danger that derivatives can generate is not lost to financial regulatory bodies and elected politicians. However, their historical record in grappling with these risks has not always been well-thought-out or adequate.
Historical Regulation of Derivatives
The Securities Exchange Act of 1934[xx] was perhaps the most important piece of financial regulation in the history of the United States. It established the Securities and Exchange Commission and gave it the power to enforce a broad set of rules covering the secondary trading of equity and debt securities. Derivatives and commodities were left out of the legislation’s subject matter.
Among the first attempts at derivatives regulation was the 1921 Futures Trading Act[xxi], prompted by collapsing agricultural prices following the end of the First World War and a report by the Federal Trade Commission that futures speculation was causing volatility in agricultural prices. The act sought to curb this speculation by placing a tax on futures contracts traded on an exchange not licensed by the federal government. Soon, however, the Supreme Court ruled the act unconstitutional in relying on the taxing authority of Congress[xxii].
In response to the Court’s ruling, Congress passed the Grain Futures Act in 1922[xxiii] after speculation in futures markets surged in the wake of the decision. The bill created a three-member commission comprising the Attorney General, Secretary of Agriculture, and Secretary of Commerce to enforce its provisions of requiring exchanges to be licensed by the federal government. The new bill relied on the power given to Congress in the commerce clause and was upheld by the Court in 1923.[xxiv]
Just as the Securities Exchange Act of 1934 confronted the excesses in securities markets that were believed to have led to the Great Depression, Congress again addressed speculation in commodity and derivative markets in 1936, culminating in the Commodity Exchange Act.[xxv] The act placed an outright ban on the trading of commodity options and placed more stringent record keeping requirements on licensed exchanges.
Little changed in the way of the regulation of derivatives in the United States until the 1974 passage of the Commodity Futures Trading Commission Act[xxvi], which created the independent agency of the same name, subjecting oversight to the requirements of Administrative Law and removing them from the President’s cabinet.
Clearly, with substantial subsequent innovation in derivatives markets that made these prior regulations anachronistic, politicians and regulators would at some point be forced to choose between leaving parts of the market unregulated or modernizing the regulatory approach that was being taken. Congress decided to go down the path of non-regulation after the chairman of the CFTC, Brooksley Born, moved to regulate the enormous over-the-counter derivatives market in swaps in 1998.[xxvii] As a matter of law, the CFTC had been granted exclusive authority to regulate derivatives markets – whether cleared through exchanges or over-the-counter – by both the 1936 Commodities Exchange Act and the 1974 Commodities Futures Trading Commission Act. As the over-the-counter derivatives market exploded in size, it was not altogether unreasonable that the CFTC would take action to regulate a market built upon bilateral contracts invisible to regulators.
Two factors largely blocked Born and the CFTC from doing so. The first was a renaissance in laissez-faire and free market thinking from a diverse cadre of Washington policy makers[xxviii], notably Federal Reserve Chairman Alan Greenspan, Treasury Secretary Robert Rubin, and his most senior assistant, Larry Summers. The malaise of the United States economy in the 1970s was powerful evidence to many that regulatory regimes instituted during the Depression were doing more harm than good and were unnecessary because markets are self-regulating. Speaking to the Futures Industry Association in 1999, Greenspan made the following remarks:
“Of the $33 trillion outstanding at year-end, only $4 trillion were exchange-traded derivatives; the remainder were off-exchange or over-the-counter (OTC) derivatives. The greater use of OTC derivatives doubtless reflects the attractiveness of customized over standardized products. But regulation is also a factor; the largest banks, in particular, seem to regard the regulation of exchange-traded derivatives, especially in the United States, as creating more burdens than benefits. As I have noted previously, the fact that the OTC markets function quite effectively without the benefits of the Commodity Exchange Act provides a strong argument for development of a less burdensome regime for exchange-traded financial derivatives.”[xxix]
In other words, Greenspan believed that regulation in the exchange-traded derivatives market was driving much of the increase in the outstanding amount of over-the-counter derivatives as well as a desire for customized contracts. Chairman Born had testified to Congress in the previous year about the need for significant regulation of these products to avoid systemic risks that she feared would be inevitable. Interestingly, Born’s view seems to be factually opposed to Greenspan’s in that customization, from her perspective, was not driving increases in over-the-counter swaps trading since many of these bilateral contracts were becoming increasingly standardized:
“The swaps market also has experienced a proliferation of new products and proposed new trading systems. While the Part 35 exemption does not extend to swap agreements that are part of a fungible class of agreements, market information indicates that some swap agreements have become increasingly standardized, indicating a need to consider broadening the exemption under appropriate terms and conditions. Furthermore, the swaps exemption does not permit clearing of swaps or trading of them through multilateral transaction execution facilities, but developments in the marketplace have indicated a significant demand for both.”[xxx]
The second factor that undeniably worked against the CFTC in its desire to regulate over-the-counter swaps was the immense influence that financial institutions now had in Washington and their desire to maintain income streams from the sale of these swaps. According to the website Open Secrets, financial firms spent more than $200 million in lobbying during 1998.[xxxi]
Ultimately, the Commodity Futures Modernization Act of 2000[xxxii] passed in the House of Representatives by a vote of 377-4. It forbade the CFTC from regulating over-the-counter swaps.
It cannot be stated with certainty how subsequent events would have unfolded if Congress had decided differently, but it can be stated with reasonable certainty that financial derivatives, including credit default swaps, made some contribution to the 2008 global financial crisis, if only because the products were singularly responsible for causing the bankruptcy of American International Group.
Washington’s primary response to the financial crisis was the Wall Street Reform and Consumer Protection Act[xxxiii], commonly known as “Dodd-Frank” due to the sponsors of the bill. The act provided for a myriad of new regulations and was varied in its purposes.[xxxiv] In regards to derivatives, the goal of legislators was to bring derivatives onto exchanges where more transparency existed and greater regulation was possible. Swaps were required to be brought onto exchanges in Title VII of the act and regulatory authority for derivatives was vested in both the CFTC and the SEC. Dodd-Frank also created procedures for the unwinding of financial institutions deemed systemically important. While ostensibly the provision was not regulation concerning derivatives markets, it was clearly aimed, at least partially, at preventing counter-party contagion in the midst of another crisis.
In 1910 an historically enormous fire consumed forests in Idaho and Montana. The destruction proved helpful to President Theodore Roosevelt as he sought to insert the federal government into the protection of certain tracts of land.[xxxv] Perhaps he thought of the situation when he famously said, “Risk is like fire: If controlled it will help you; if uncontrolled it will rise up and destroy you.”
Throughout their history, financial derivatives could accurately be compared to fire. Unquestionably, these instruments have enabled and improved commerce in a multitude of civilizations throughout modern history and have played an important role in the development of the American financial system. However, if left to spread uncontrollably, they are also capable of concentrating risk on a few institutions and toppling seemingly strong companies like dominoes.
Derivatives are arguably as regulated today as they have ever been due to post-financial-crisis legislation and vigilance among regulatory authorities upon observation of the carnage of the crisis. However, it is largely unknown what amendments to the legislation will result from the incoming administration of President-elect Trump.
Some observers are likely to take a free-market-oriented approach that encourages innovation and seeks to reject the ice of malaise, while others are more likely to focus regulatory efforts on stability, thereby containing potentially out-of-control fires. Indeed, although Dodd-Frank provides for the central clearing of swaps, numerous loopholes still exist. We will be able to determine the future path of the fire only in retrospect.
[i] Richard W. Stevenson, The Collapse of Barings: An Overview, N.Y. Times, Feb. 28, 1995.
[ii] Michael Shnayerson, Wall Street’s $18.4 Billion Bonus, Vanity Fair, March 2009.
[iii] See Testimony of Richard C. Breeden, Chairman, Financial Services Group Coopers & Lybrand, Concerning Supervision of Derivatives Markets before the Subcommittee on Telecommunications and Finance (1994) for a contextual overview of regulatory concerns regarding derivatives. Retrieved from the SEC Historical Library at http://3197d6d14b5f19f2f440-5e13d29c4c016cf96cbbfd197c579b45.r81.cf1.rackcdn.com/collection/papers/1990/1994_0510_BreedenDerivatives.pdf
[iv] Ernst Juerg Weber, A Short History of Derivative Security Markets, Discussion Paper, August 2008, The University of Western Australia.
[v] Steve Kummer and Christian Pauletto, The History of Derivatives: A Few Milestones, EFTA Seminar on Regulation of Derivatives Markets, Zurich, May 3, 2012.
[vi] Fischer Black and Myron Scholes, The Pricing of Options and Corporate Liabilities, The Journal of Political Economy, Vol. 81, No. 3, May-June, 1973, pp. 637-654.
[vii] See Ajay Shah, Black, Merton and Scholes: Their Work and Its Consequences, Economic and Political Weekly, December 1997.
[viii] Report to Congress on the Effect of the Absence of Fixed Rate Commissions, December 1, 1975, Securities and Exchange Commission. Retrieved from the SEC Historical Library at http://3197d6d14b5f19f2f440-5e13d29c4c016cf96cbbfd197c579b45.r81.cf1.rackcdn.com/collection/papers/1970/1975_1201_SECAbsenceFixed.pdf
[ix] Charles M. Jones, A Century of Stock Market Liquidity and Trading Costs, May 22, 2002.
[x] See “A FICC for your Troubles,” The Economist, May 11, 2013.
[xi] Sheelah Kolhatkar, The Legacy of JP Morgan’s Blythe Masters, Bloomberg BusinessWeek, April 3, 2014.
[xii] For context, see The Internationalization of our Securities Markets, An Address by Ray Garret, Jr., Chairman of the Securities and Exchange Commission, September 25, 1973. Retrieved from the SEC Historical Library at http://3197d6d14b5f19f2f440-5e13d29c4c016cf96cbbfd197c579b45.r81.cf1.rackcdn.com/collection/papers/1970/1973_0925_Garrett_BSE_Speech.pdf
[xiii] 12 CFR Section 220.12.
[xiv] The Berkshire Hathaway vice-chairman is quoted in the book Poor Charlie’s Almanack (edited by Peter Kaufman) as saying: “I think a good litmus test of the mental and moral quality at any large institution would be to ask them, ‘Do you really understand your derivatives book?’ Anyone who says yes is either crazy or lying.”
[xv] Roger Lowenstein, When Genius Failed: The Rise and Fall of Long-Term Capital Management, 2000.
[xvi] Based on data from the Office of the Comptroller of the Currency (OCC).
[xvii] See pages 13-15 of Berkshire Hathaway’s Annual Report to Shareholders for comments on derivative risks, including counterparty risk.
[xviii] Jerome H. Powell, Central Clearing in an Interdependent World, November 17, 2015, Federal Reserve Bank of New York.
[xix] An extreme example of this phenomenon can be seen in reverse when during the financial crisis it became extremely difficult to place market values on illiquid instruments. See Letter of US Representatives to SEC Chairman Christopher Cox dated September 30, 2008. Retrieved from the SEC Historical Library at http://3197d6d14b5f19f2f440-5e13d29c4c016cf96cbbfd197c579b45.r81.cf1.rackcdn.com/collection/papers/2000/2008_0930_CongressMarktoMarket.pdf
[xx] 15 CFR Section 78a.
[xxi] 42 Stat. 187.
[xxii] 259 U.S. 44 (1922).
[xxiii] 42 Stat. 998.
[xxiv] 262 U.S. 1 (1923).
[xxv] 49 Stat. 1491.
[xxvi] 88 Stat. 1389.
[xxvii] See “Brooksley Born, the Cassandra of the Derivatives Crisis,” by Manuel Roig-Franzia and published in The Washington Post, May 26, 2009.
[xxviii] See the May 7, 1998 joint statement of Alan Greenspan, Robert Rubin, and Arthur Levitt. Retrieved from the SEC Historical Library at http://3197d6d14b5f19f2f440-5e13d29c4c016cf96cbbfd197c579b45.r81.cf1.rackcdn.com/collection/papers/1990/1998_0507_NewsJoint.pdf
[xxix] Available from the Federal Reserve at https://www.federalreserve.gov/boarddocs/speeches/1999/19990319.htm
[xxxi] For further discussion, see “How Wall Street Defanged Dodd-Frank,” by Gary Rivlin and published in The Nation, April 30, 2013.
[xxxii] 7 U.S.C. 1.
[xxxiii] 124 Stat. 1376.
[xxxiv] For context, see “Main Street and Wall Street,” by Gene Rotberg, from Jan. 27, 2009. Retrieved from the SEC Historical Library at http://3197d6d14b5f19f2f440-5e13d29c4c016cf96cbbfd197c579b45.r81.cf1.rackcdn.com/collection/papers/2000/2009_0127_RotbergMain.pdf
[xxxv] Timothy Egan, The Big Burn: Teddy Roosevelt and the Fire that Saved America (2009).