Derivatives: No longer a dirty word

Financial `derivatives` in the mid to late 1990s were generally known for one thing: disasters. Whether it was the Orange County debacle, the Proctor & Gamble fiasco or indeed the most celebrated event of them all, Nick Leeson`s blowing up of Barings, `derivatives` were synonymous with financial disasters, and on an enormous scale.

We even had our own South African episodes at Real Africa Durolink and WJ Morgan. However, in all of these cases, the underlying cause of the disaster was not the derivative contracts per se, but the inappropriate use and management of the derivative contracts.

Derivative contracts by themselves are not `dangerous`. It is the use of the derivative contracts that can become problematic; in the case of Barings, the disaster was a result of appalling management and a complete lack of control when it came to the administration of the derivative positions. With Orange County, the disaster occurred as a result of a spectacularly disastrous bet on the direction of interest rates; derivatives were employed to facilitate this `bet` but did not cause the bet to be placed in the first place.

With Real Africa Durolink, once again it was very poor controls and procedures which led to the loss. In all these events it has not been the derivative contracts which have resulted in the losses, but the speculative positions or `bets` that were chosen in the first place, or the poor controls that were in place with the administration of the derivatives.

The term `derivative` refers to a very broad spectrum of financial products and it is partly as a result of this lack of standardisation of derivatives that we have seen some of the disasters that have occurred. Simply put, there is no standard derivative; each of them has their own peculiarities, differences and nuances. As a result of this lack of standardisation or commonality, when derivatives first came into the mainstream there was a lack of understanding of them and hence no formal approach to dealing with the associated risks. Things simply got out of control, resulting in the disasters which we have seen.

We have progressed dramatically since then; the management of derivatives both in terms of the risks which the derivatives generate, together with the control processes surrounding the administration of derivatives has improved substantially. Financial professionals, managers and most sophisticated clients now fully understand them and use them appropriately. As a result of this, derivatives, employed correctly, can be used to substantially reduce risk and create very user-friendly, efficient products.

Probably the best example of this is the proliferation of the fixed rate mortgage, or indeed mortgages with `caps` which we see in most European economies. These relatively common products are created through extensive use of financial derivatives and reduce mortgage holders` risks considerably. Furthermore, derivative contracts such as futures or Contracts For Difference (CFDs), which expose traders to the change in the value of an asset without having to own the underlying asset itself, are far more efficient than traditional financial products such as equities, with the efficiency gains being passed on to the end-user. An equity CFD mirrors exactly what an equity does, but the cost of trading an equity CFD is 0.35% while trading most equities in SA costs about 1%. Furthermore, CFDs avoid the 0.25% MST which equity trading incurs.

So in summary, derivatives should no longer be a dirty word; once understood and employed properly they provide tremendous efficiency and can reduce risks substantially which ultimately benefits the consumer. Derivatives should be embraced, but most importantly understood first.