WMD or Insurance?
penny prabha is an economist at the Milken Institute. keith savard is senior managing economist at the Institute and Heather Wickramarachi is a senior research analyst there. This is a nontechnical adaptation of a more comprehensive report by the authors, which is available to download at milkeninstitute.org. The research was supported by the CME Group, which owns and operates derivatives exchanges. However, the views expressed are those of the Milken Institute.
April 28, 2014
Far from the financial weapons of mass destruction that Warren Buffett imagined, and contrary to the common narrative that blamed them in part for the Great Recession, derivatives have been a boon to the U.S. economy. Indeed, by our estimate, derivatives boosted GDP by over one percent from 2003 to 2012. We'll flesh that out below.
But first, some terminology. Yes, a bit of a bore. But you can't tell the players without a scorecard.
Derivatives, broadly defined, are contracts to engage in a transaction in the future. The value of the contract is derived from the price of an underlying asset (a stock, or perhaps a commodity) or a market variable (interest rate, currency exchange rate, stock index, credit risk). The notional amount of a derivative contract refers to the principal value of the underlying asset – say, the $10 million face value of a bond insured by a credit default swap derivative. Counterparty risk is the chance that the enterprise on the other side of the contract won't honor its obligations.
Derivatives-exchange markets trade standardized contracts, interposing a clearinghouse that insures each party honors its obligations. Derivatives traded "over the counter" are privately negotiated and customized to the specifications of the parties involved. They are executed bilaterally, in most cases through dealers (such as commercial and investment banks) that either find a counterparty for the other side of the contract or serve as the counterparty themselves.
The new federal Dodd-Frank law generally requires, in contrast to past practice, that OTC derivatives be cleared by a derivatives-clearing organization and that the transactions trade on swap-execution facilities or designated contract markets. European regulators and some Asian nations are taking a similar approach. However, it is unclear whether all of the G-20 will concur.
The four main types of derivatives contracts are forwards, futures, options and swaps. Differences among them include some of the functions and features of the contracts and the markets where they are traded. Forwards and futures contracts are agreements to complete a financial transaction at a specified price and quantity at a future (forward) date. Forwards, unlike futures, are customized through negotiation. Since such contracts are bilateral, the participants are exposed to counterparty risk – that is, no third party stands between them to guarantee performance of the contract.
Futures are traded on organized exchanges. Risk to parties (and the clearinghouse) is minimized because collateral is required from both sides.
An option is a contract that grants owners the right, but not the obligation, to purchase (call) or sell (put) an asset for a specific price by a specific date. The purchaser/owner pays the seller/writer an option premium for the right. The purchaser's potential loss is limited to the amount of the premium, curbing the downside. In contrast, the seller of an option receives the premium in return for risk exposure. Options are traded on organized exchanges and OTC derivatives markets, though standardized options are traded solely on organized exchanges.
A swap is a contract to exchange a set of payments one party owns for a set of payments owned by the other. The type most commonly traded is the interest-rate swap, which has increased in importance as financial institutions seek to manage interest-rate risk. Swaps, like forwards, are traded on the OTC market and are subject to counterparty risk. However, under the new Dodd-Frank rules, most swaps are now required to be cleared by a derivatives clearing organization and executed on a swap-execution facility.
Where They Came From
Enough of definitions. Now for some history, ancient and modern. In the wake of the battle over who (or what) caused the financial crisis, readers may be forgiven for assuming that derivatives were invented while Bill Clinton or George Bush was president. In fact, the first known use of derivatives dates to about 2000 B.C., when merchants in the Persian Gulf region engaged in consignment transactions for goods destined for India. The use of derivatives to manage risk in trade and currency exchange flowered in the Renaissance, with much of the activity taking place in Italy. Markets became specialized to respond to the trading needs of varied merchant groups. For their part, derivatives largely remained, in today's terminology, over the counter – but with the counters closely aligned with the individual markets.
By 1600, forward and options contracts on commodities, shipments and securities were being traded in Amsterdam. This was followed a few decades later by forward contracting on tulip bulbs during the infamous Tulip Mania. A standardized futures contract for rice was being used in Osaka, Japan around 1650, although it is not known whether the contracts were regularly marked to market (that is, regularly revalued to reflect market conditions) or included credit guarantees, or both.
The first formally regulated exchange for derivatives was the Royal Exchange in London, founded in 1565. England got a jump on the continent because English law recognized the transferability and negotiability of bills of exchange. Settlement was also facilitated through contracts for difference, in which a losing party could compensate the winning party for the difference between the delivery price and the spot price at the termination of the agreement.
The trading of derivatives in 18th century England also brought us the term "bubble." When the South Sea joint stock company was established in 1711, its exclusive trade with Spain's South American colonies was widely expected to generate enormous profits. This led to the formation of ancillary companies called bubbles. But in 1720, Parliament passed the Bubble Act, prohibiting all joint stock companies not authorized by royal charter. The law triggered turmoil in financial markets, resulting in a crash. According to a subsequent investigation, the breakdown was attributed to those who dealt in options – mainly call options known as refusals. Parliament subsequently banned both options in shares and the practice of short-selling.
The first formal commodities exchange, the Chicago Board of Trade, was established in 1848 to provide a centralized location for negotiating forward contracts. Under its aegis, the first exchange-traded derivatives contracts were listed in 1865, and in 1925 the first futures clearinghouse was formed. (In 2007, the Chicago Board of Trade merged with the Chicago Mercantile Exchange to become the CME Group.)
The recent history of derivatives is characterized by their broad integration across commerce and finance, with trading in everything from sulfur-emissions-containment credits (for utilities) to heating-degree days (a weather variable). In the final decades of the 20th century, there was derivatives trading on currencies, bond and interest-rate futures and even options on securities indexes. The first currency futures were launched in 1970 at the International Commercial Exchange in New York, when fixed-exchange-rate regimes still dominated.
Five years later, the interest-rate futures contract based on Ginnie Mae mortgages was traded for the first time on the Chicago Board of Trade. This was followed in 1977 by the U.S. Treasury bond futures contract, which quickly became the highest-volume contract traded. The flurry of activity continued with the creation of the Chicago Mercantile Exchange's Eurodollar contract in 1982 and of the first stock-index futures contract by the Kansas City Board of Trade. The Chicago Mercantile Exchange quickly followed with its contract on the S&P 500 index.
The 1980s ushered in the beginning of the era of swaps and other over-the-counter derivatives. With the arrival of a new generation of corporate financial managers well-versed in risk-management techniques, these instruments became the go-to ones for hedging interest-rate, exchange-rate and commodity-price changes. By 1991, the notional amount of OTC derivatives outstanding had surpassed that of exchange-traded derivatives.
The rapid growth in OTC derivatives was fueled in part by the emergence of credit derivatives in the mid-1990s. The first credit default swaps – effectively, insurance contracts on loans – were created by the J.P. Morgan investment bank (now JPMorgan Chase), which led the industry away from relationship banking toward credit trading.
The Party and the Morning After
Despite all the positives associated with derivatives in the 1990s, a number of high-profile events raised concerns. In 1994, firms with deep financial experience, such as Procter & Gamble and Metallgesellschaft (a giant German industrial conglomerate), suffered large losses on derivatives trading – primarily using swaps. Orange County, in California, one of the wealthiest counties in the United States, declared bankruptcy, due partly to losses on derivatives trading involving leveraged repurchase agreements. The following year, Britain's Barings Bank declared bankruptcy after losing billions through speculation on futures by a rogue trader in its Singapore office.
These events led to minor changes in the way derivatives were regulated, but for the most part firms remained responsible for tightening controls internally.
Following the 1998 collapse of Long-Term Capital Management, a giant hedge fund, the report of the President's Working Group on Financial Markets recommended that the SEC, the Commodities Futures Trading Commission and the U.S. Treasury be given expanded authority to regulate derivatives. The proposal would have required counterparties in OTC transactions to provide credit-risk information and keep records on concentrations, trading strategies and risk models. But the Fed's chairman, AlanGreenspan, declined to endorse those proposals, deferring to regulators who had existing supervisory authority – and who ignored the recommendation.
Then, in late 2000, Congress passed the Commodity Futures Modernization Act. The law removed OTC derivatives transactions from all requirements of exchange trading and clearing, so long as counterparties to swaps met minimum standards. Except for issues related to fraud, the SEC was barred from OTC derivatives oversight. Moreover, the new law expressly preempted state gambling and anti-bucket-shop laws, which would have barred the otherwise unregulated speculative activity granted under the Act.
In the aftermath of the law's passage, derivatives growth skyrocketed. Although this boom was generally viewed as a positive step in helping to mitigate business risk, regulators and swap dealers themselves expressed reservations about operational shortcomings of OTC markets. In 2005, Timothy Geithner, then the president of the powerful Federal Reserve Bank of New York, assembled representatives of the world's 14 largest banks to discuss his concern about substantial backlogs in the documentation of credit derivatives. He requested that banks clear up 80 percent of the backlog within a year and asked them to form a clearinghouse for complex derivatives contracts.
For critics of OTC derivatives, and credit derivatives in particular, the global financial crisis beginning in 2008 was seen as validation of their views, while presenting an opportunity for reform. The belief that derivatives were indeed Warren Buffett's financial weapons of mass destruction added to the momentum for change. The final report of the National Commission on the Causes of the Financial and Economic Crisis in the United States took a more nuanced view. While acknowledging that OTC derivatives contributed "significantly to this crisis," the report cited them as just one of eight major factors involved.
The Dodd-Frank act, which was signed into law in July 2010 (five months before the release of the Financial Crisis Inquiry Report), reflected negative public sentiment toward derivatives. Title VII of the act granted the Commodities Futures Trading Commission and the SEC authority to regulate swap derivatives, with the SEC assigned power over securities-based swaps. Other parts of the law addressed broader issues of interconnectedness among market-making firms and concentrations of risk in derivatives markets.
It's too early to judge whether Dodd-Frank's remedies will work. Many of the measures linked to changes to OTC derivatives and the requirement to use swap-execution facilities have been put in place only recently. But there's little doubt that derivatives will continue to play a pivotal role in financial markets.
Volatility and Technology
While the derivatives markets were small until the 1970s, rising volatility in stocks, interest rates and exchange rates since then, along with the globalization of the capital markets, has spurred demand for instruments to hedge risk. Supply factors, notably the rise of financial engineering built on a platform of cheap, rapid digital computation and the Black-Scholes option-pricing formula, also played a major part.
The size of the global market for OTC derivatives, as measured by the notional amount outstanding (more on that concept later), grew from $80 trillion in 1998 to $633 trillion in 2012. The exchange-traded market expanded considerably as well over that period, from $14 trillion to $54 trillion.
Among the four types of derivatives, swaps are the largest market by notional amount, with forwards in the runner-up position. Both are traded over the counter, while futures and standardized options are traded on organized exchanges. Comparing notional amounts outstanding between exchanges and OTC derivatives markets can be misleading, however. OTC trading data capture gross positions, while exchange data represent net positions. Therefore, the growth of derivative types is better compared within the markets in which the instruments are traded.
Interest-rate derivatives are the most widely traded, accounting for three-quarters of notional amounts outstanding. They became popular in the late 1970s and early 1980s, when corporations – banks, in particular – were grappling with wide rate fluctuations and sought financial instruments to reduce the associated risk.
Foreign-exchange derivatives, at 11 percent of the notional amount of the global OTC total, are the second-largest category.
In recent decades, foreign financial markets have become more accessible and international trade more open as technology reduced informational and other costs associated with cross-border transactions. The foreign-exchange-derivatives market expanded accordingly, from the notional amount of $18 trillion in 1998 to $67 trillion in 2012. Activity in equity-linked and commodity derivatives is relatively small, with each accounting for about 1 percent of the broader market.
The credit default swap is the predominant form of credit derivative. With such a swap, a buyer seeking insurance against an adverse event – a ratings downgrade on the issuer's debt, for example – makes periodic payments to a protection seller. If an event occurs, the seller is obligated to make the buyer whole. The primary buyers and sellers of credit default swaps are financial institutions.
Over the past 10 years, the credit default swap market has grown at an astounding pace. The notional amount outstanding peaked at $58 trillion at year-end 2007, a nine-fold growth since 2004. However, when compared to some other types of derivatives – for example, interest-rate swaps – the credit default swap market is relatively small.
One reason for such swaps' rapid growth was the heated activity in the housing market and the expansion of mortgage-backed securities. Many financial institutions that invested in mortgage-backed securities purchased credit default swap contracts to protect against default. The market for such swaps declined amid the financial crisis, and has not returned to previous levels.
Exchange-Traded vs. OTC
Last year, 21.2 billion derivatives contracts were traded on organized exchanges worldwide, close to triple the volume of just a decade ago. Europe and North America dominate exchange-traded derivatives, with 90 percent of the action. Although the major derivatives exchanges (for example, CME Group, Deutsche Börse AG, ICE/NYSE) are located in mature economies, demand for such products is rising in emerging economies. Derivatives exchanges in Brazil, China, India, South Korea and Russia have shown remarkable growth and are now ranked among the busiest.
The scale of the notional amount of outstanding derivatives contracts at the end of 2012 – $633 trillion, or 10 times world GDP – seems alarming on its face. However, notional amounts outstanding don't contain much information about what's inherently alarming here – the risk to counterparties.
For example, suppose an investor buys a derivative contract from a bank to hedge the credit risk of holding $1 million in IBM bonds. Assume further that the investor pays an annual premium of $1,000 in exchange for reimbursement of the bond's par value, were IBM to default. In that case, the notional amount is $1 million. The $1,000 premium, or cash-flow obligation of the investor, is the fair value of the contract and the amount at risk for the bank. Moreover, a bank can mitigate the risk of not being paid the premium by an investor by entering into a new contract with that same investor (for example, by buying a new contract on IBM bonds). The sum of the fair values of the outstanding contracts between the parties is known as gross market value. And in 2012, gross market value worldwide was $24.7 trillion, or just 3.9 percent of the notional amount.
In the United States, banks can benefit from netting and posting collateral from a master netting agreement in accordance with generally accepted accounting principles. Based on the IBM example, the bank has a positive fair value from the first contract and a negative fair value in the second contract. The sum of positive and negative fair values between the counterparties (i.e., the bank and the investor) after bilateral netting is known as gross credit exposure. And the gross credit exposure of global derivatives was $3.6 trillion at the end of 2012, just 0.57 percent of the notional amount outstanding. Moreover, collateralization further reduces counterparty risk exposure to 0.17 percent of the notional amount – real money, but not the stuff of global-catastrophe scenarios.
Exchanges offer the advantage of pre-trade price discovery for potential participants and a high level of transparency. Moreover, they use a clearinghouse to clear and settle trades and to assume counterparty risk. In a traditional bilateral OTC transaction, by contrast, the contract participants bear the risk of each other's default. Note that the risk can become systemic, because losses from defaults can spread to parties who entered into contracts with the counterparties of the defaulted contracts, which explains why Washington intervened to save counterparties in the collapse of AIG, and why reformers want to force OTC derivatives to be cleared by a well-financed third party.
But the swift growth of the OTC derivatives market before the crisis does reflect some real advantages of this platform. In particular, enterprises can trade customized, complex or illiquid products, giving them the flexibility to tailor derivatives to the hedge risks of specific assets in their portfolios.
First consider banks, which hedge with derivatives, but also make markets in these instruments to generate fees. Banks' assets (such as mortgage and commercial loans) are typically long-term, while their liabilities – notably, demand deposits – typically have much shorter terms. The resulting maturity mismatch between assets and liabilities subjects banks to interest-rate risk. That is, a change in relative interest rates impacts banks' earnings, because much of their profit comes from the difference between interest received on loans and interest paid on deposits. To reduce their exposure, banks use interest-rate derivatives. That, of course, serves the banks by reducing the risk of failure and may also reduce the risk of systemic financial market failure. But it also reduces the cost of lending, increasing the efficiency of capital markets.
Most banks thus depend heavily on interest-rate derivatives. In fact, those derivatives account for 80 percent of total derivative notional amounts. Banks also use derivatives to hedge against foreign-exchange-rate and commodity-price volatility and to insure against loan defaults. But more than 90 percent of total notional amounts are held for trading (rather than hedging) purposes, and are thus a major source of fee income.
Note that derivatives activity in U.S. banking is highly concentrated. Fully 93 percent, measured in total notional amounts, is held by just four banks: JPMorgan Chase, Citibank, Bank of America and Goldman Sachs. Research suggests that the main reasons for this concentration are economies of scale in hedging and market participants' strong preference for trading with highly rated, large dealer banks that presumably pose less counterparty risk.
Nonfinancial firms are also major participants in the derivatives market. Cash-flow volatility, which can arise from adverse changes in interest rates, foreign exchange rates and commodities prices, can rob firms of the liquidity needed to meet fixed costs. Hedging can reduce the likelihood and costs of financial distress. Furthermore, hedging the volatility of cash flow and profits reduces the cost of borrowing and can be used to reduce tax liability.
At least one study has found that option prices on individual equities reflect market conditions more quickly and accurately than the stocks themselves do. Similarly, the research suggests similar conditions in credit and commodity markets.
Moreover, the addition of derivatives to an underlying market brings in additional players who use derivatives as a leveraged substitute for trading the underlying asset. By the same token, derivatives may cut transaction costs through narrower bid-ask spreads. Consequently, spot markets with parallel derivatives markets typically are more liquid and have lower transaction costs than markets without them. One clear example: an investor who wants exposure to the S&P 500 but hopes to avoid the expense of purchasing all the underlying securities can trade index options and futures for the same exposure, at far lower cost.
Economic Impact, by the Numbers
To fully appreciate this study's empirical findings, it is important to understand how they were arrived at. The use of derivatives by banks and nonfinancial firms has an indirect impact on economic growth via a variety of channels. To capture the overall impact, the analysis is divided into two steps.
First, we estimate the influence of banks' use of derivatives on lending and the effects of nonfinancial firms' use of them on firm value. Our statistical analysis demonstrates that banks' derivatives use allows for a larger volume of commercial and industrial loans (holding other factors constant), thereby increasing business investment. Additionally, it confirms that investors assign higher valuations to nonfinancial firms using derivative products, and those valuations boost firms' incentives and ability to expand operations.
In estimating the broad macroeconomic effect, we used two alternate approaches. One is based on a pure measure of statistical association that uses current and past values of variables in a system to determine their relationships. A key advantage is that a limited number of variables is necessary to perform the estimation. The second approach uses a structural model of the economy. This provides a separate estimate of the resulting changes in real GDP growth and includes further detail on investment, industrial production, employment, wages and incomes, and consumption, in addition to many other variables. Nevertheless, the approaches yield consistent results, warranting a high level of confidence.
The technical complete analysis is spelled out in the full report, which can be downloaded from the Milken Institute Web site. Here, we offer the key findings:
- Banks' use of derivatives, by permitting greater extension of credit to the private sector, increased U.S. quarterly real GDP by about $2.7 billion each quarter from the first quarter of 2003 to the third quarter of 2012.
- Derivatives use by nonfinancial firms increased U.S. quarterly real GDP by about $1 billion during the same period by improving their ability to undertake capital investments. (Over this period, U.S. real GDP grew by $66 billion per quarter on average.)
- Combined, derivatives expanded U.S. real GDP by about $3.7 billion each quarter. The total increase in economic activity was 1.1 percent ($149.5 billion) between 2003 and 2012.
- Between 2003 and 2013, derivatives' use boosted employment by 530,400 (0.6 percent) and industrial production by 2.1 percent.
We separately examined the benefits of exchange-traded derivatives. The use of futures contracts has a positive association in all statistical formulations, suggesting that they help both banks and nonfinancial firms manage risk and thereby enable banks to extend more loans and firms to invest more capital. In the full sample period 2003 to 2012, we estimate that futures use is associated with a $1.5 billion quarterly increase in real U.S. GDP. Note, however, that this estimate does not refer to the benefit of futures over other derivatives types, since firms that hedge with futures often use more than one type of risk-management tool at a time.
Down the Road
It's possible that the spectacular pace of growth in derivatives creation before the financial crisis will resume once users understand the market's ongoing transformation. By the same token, it's possible that derivatives will migrate to exchanges as the advantages become more apparent and regulation reduces the flexibility of OTC operations. This could prove the best of all possible worlds, as exchange trading will adequately meet business demand for risk management without the systemic risk posed by OTC trading.
But it is premature to predict that rosy scenario. For one thing, cross-border, margin and Basel III regulations are not fully in place, creating uncertainty about how regulation will affect the derivatives market. For another, chief financial officers have not had the time to evaluate the new regulations, and some are concerned that the push toward standardization will narrow their choices about how to hedge.
The primary aim of the new regulatory structure created by Dodd-Frank – one that will have much more bite on the OTC market – is to reduce counterparty risk (and thus systemic risk). Henceforth, all standardized swaps must be executed through a swap-execution facility or a designated contract market. Moreover, the agreements will need to be cleared at a derivatives-clearing organization and reported publicly via a swap-data repository.
Industry experts project that 60 percent or more of over-the-counter derivatives trading volume will be centrally cleared. The actual percentage will depend in part on how banks, as liquidity providers, rethink product distribution to clients. Bankers are warning that as swaps trading volume through clearinghouses ramps up, counterparty risk will actually increase because the clearinghouses lack adequate capital – a worry, by the way, that clearinghouse executives vehemently dispute.
In addition to the issue of capital adequacy, there is concern that new regulations will reduce the efficiency of the derivatives market by tilting toward exchange trading and against cleared swaps. In particular, because the Commodity Futures Trading Commission delayed issuing regulations for swap execution facilities, the exchanges had head starts in establishing their businesses. The commission also issued rules that favor futures. With block trades, exchanges can set size limits on their own, whereas swap-execution facilities must follow a formula established by the commission Moreover, under the new rules, market participants are currently required to post significantly more collateral to clear a swap transaction than a similar future.
Prior to Dodd-Frank, the lack of regulated margin (collateral) requirements was a major driver of the growth of swaps markets. The imposition of such requirements on both cleared and un-cleared swaps will have a noticeable impact on the cost of hedging. The issue of margin requirements is made all the more acute by the impact of deleveraging, which has been ongoing since the financial crisis. According to industry sources, the total margin shortfall under the new market structure could range from $800 billion to more than $2.5 trillion. However, although these estimates appear large, advances in financial engineering are likely to dampen their impact.
It remains to be seen whether the cost of meeting margin requirements will spur the migration of OTC derivatives activity to exchanges. Whatever the outcome, there is little doubt that a great deal of exotic-derivatives activity will cease in the face of margin requirements and the additional charges likely to be imposed by clearinghouses on these less-liquid bilateral trades. According to a study by the Tabb Group, more than $130 trillion in derivatives' notional value might not be clearable.
Dodd-Frank has not only created a seismic shift in non-exchange-traded derivatives markets in the United States, but has also sent tremors through overseas markets. The big issue: whether U.S. regulators would require non-U.S. entities (including foreign branches of American banks) that are engaged in swap trading with a U.S. entity to comply with U.S. rules. Foreign regulators, particularly those in Europe, have strenuously objected to such an approach. For their part, U.S. banks have objected to extraterritoriality, believing they would be placed at a competitive disadvantage.
In July 2013, the Commodities Futures Trading Commission agreed to phase in new rules and to create a process that could ultimately allow foreign banks to comply with home-country rules rather than the commission's. With luck, this will allow for the smooth operation of global derivatives markets going forward. Much, however, will depend on whether the regulations are sufficiently synchronized across jurisdictions to limit opportunities for regulatory arbitrage.
EU-related derivatives activity is also undergoing change – albeit at a slower pace –through the Review of the Markets in Financial Instruments Directive and the European Market Infrastructure Regulation. Europe's choice of reforms will have an important bearing on the future of non-exchange-traded derivatives, since nearly two-thirds of such global transactions have taken place there. The success of all derivatives in contributing to economic growth will depend greatly on the ability of regulators and policymakers to foster more-transparent, liquid markets that can withstand stress. For end users, the litmus test will be their ability to generate competitive returns while effectively hedging risks.