Derivatives, a type of financial contract traded for trillions each year, is a thriving industry. But there’s little transparency into this complex web of trading, and many say the risks are high.
The technical definition of a derivative is “a financial contract whose value is derived from the performance of underlying market factors” such as interest rates, exchange rates, commodity and stock prices, among other things, according to the U.S. Office of the Comptroller of the Currency (OCC).
What does that mean? Derivatives are basically bets on what will happen in a certain market in the future. They derive their value from the financial instrument they’re based on.
Manipulating the future
For example, with an interest rate swap (IRS) two parties swap interest rates on a certain amount of money.
Usually, one party will pay a fixed interest rate on specific dates, while the other party will pay a variable rate that fluctuates with the market, according to the Commodities and Futures Trading Commission’s glossary.
The fixed rate buyer earns money when the interest rate stays above the fixed rate, while the other party gains money if the interest rate stays below.
This form of derivative has been especially controversial, after it was revealed that banks frequently manipulate the London Interbank Offered Rate (LIBOR) – which often guides the variable interest rate in IRS derivatives – for their own profit.
How big is the derivatives market?
According to the Bank for International Settlements (BIS), the total value of all derivatives at the end of 2014, the latest numbers available, was $630 trillion dollars.
While this may sound like a lot (in contrast, the world’s Gross Domestic Product was estimated by the World Bank to be $71 trillion in 2014), the majority of this value is notional.
That means that contracts such as interest swaps are based upon this value to calculate payment rates, but the money never actually changes hands.
According to a 2008 paper by the German exchange Deutsche Bors, derivatives have “quickly developed into the most important segment of the financial market,” fuelling innovation and providing a low-cost, global, around-the-clock market.
High reward, high risk
In addition to a susceptibility to manipulation as seen in the LIBOR scandal, however, the largely unregulated derivatives market is also often accused of contributing to systemic risk in the global economy.
According to the OCC, “Credit risk is a significant risk in bank derivatives trading.”
The Office compares it with a regular credit loan, where a lender takes the risk of of borrowing out a certain amount of money.
With derivatives, however, both parties to the contract are at risk if the other party defaults on their obligation.
If there is a default, a legally enforced “netting” agreement usually allows the losing party to demand other contracts with a positive value be added to the agreement to even out the loss.
As the value of contracts are based on future market rates, however, banks can only estimate what their exposure to risk will be in the future.
Since it’s impossible to fully predict market conditions, large-scale investments in derivatives can therefore become very unstable in volatile markets.
A famous example is the $18 billion lost by insurer American International Group on credit default swaps, a derivative meant to protect against defaults, because the company didn’t predict that their insurers would not be able to pay.
However, the industry does recognize the potential risk posed by derivatives. In a market review on credit risk and collateral in derivatives trading, the International Swaps and Derivatives Association presents a list of actions companies can take to avoid risk.
The first one?
“[A]voiding the risk by not entering into transactions in the first place,” the paper recommends.