The Post-Reform Guide to Derivatives and Futures

Gordon F. Peery

• Publisher: Wiley
• Year: 2012
• Print ISBN: 9780470553718
• eBook ISBN: 9781118205426
• Edition: 1
• Topic: Business
• Subtopic: Finance
• Index: Business

An in-depth look at the best ways to navigate the post-reform world of derivatives and futures

The derivatives market is one of the largest, and most important financial markets in the world. It's also one of the least understood. Today we are witnessing the unprecedented reform and reshaping of this market, and along with these events, the entire life cycle of a derivatives transaction has been affected. Accordingly, nearly all market participants in the modern economy need to view the handling of risk by derivatives in a very different way.

Many aspects of financial services reform are based on a belief that derivatives caused the Great Recession of 2008. While the difficulties we now face cannot be blamed solely on derivatives, the need to understand this market, and the financial products that trade within it, has never been greater. The Post-Reform Guide to Derivatives and Futures provides straightforward descriptions of these important investment products, the market in which they trade, and the law that now, after July 16, 2011, governs their use in America and creates challenges for investors throughout the world. Author Gordon Peery is an attorney who works exclusively in the derivatives markets and specializes in derivatives and futures reform and market structure. Since representing clients in Congressional hearings involving Enron Corp., he has developed extensive experience in this field. With this guide, he reveals how derivatives law, and market practice throughout the world, began to change in historic ways beginning in 2011, and what you must do to keep up with these changes.

• Explains what derivatives and futures are, who trades them, and what must be done to manage risk in the post reform world
• Accurately reflects the futures and derivatives markets as they exist today and how they will be transformed by the Dodd-Frank Wall Street Reform and Consumer Protection Act
• Highlights the risks and common disputes regarding derivatives and futures, and offers recommendations for best practices in light of the evolving law governing derivatives

The financial crisis has changed the rules of Wall Street, especially when it comes to derivatives and futures. The Post-Reform Guide to Derivatives and Futures will help you navigate this evolving field and put you in a better position to make the most informed decisions within it.

PART One:

The Crises That Led to Derivatives Reform

CHAPTER 1

Seven Causes of the 2008 Market Crises

A broken machine cannot be fixed without understanding what caused it to break. In the absence of an accurate understanding of the 2008 market crises, and if effective responses to identified causes are not properly implemented, history may repeat itself. With the fall of MF Global on October 31st, 2011, it may have already.

In fact, in at least some respects recent history repeated itself in September 2011 when massive losses—to the tune of $2.3 billion—at UBS AG resulted from derivatives trades by Kweko Adoboli, a 31-year-old Ghanaian and former UBS trader. Adoboli's trades, based on futures and exchange-traded funds or ETFs, did not set off alarms because the regulatory framework governing those trades did not require trade confirmations for some of Kweko's trades, and proper audit trails, reporting, and monitoring mandates (included in U.S. reforms as we shall see in Chapter 4) were not in place to detect or prevent the trading activity which led to billions in losses.

It is shocking that banks lost billions and the market globally lost trillions in September 2008, and then, exactly two years later, a well-regarded European bank, UBS, sustained billions in loses arising out of ETF and futures trades. One conclusion suggested by this development is that either the causes of the 2008 market crises were not properly identified, or were not in the ensuing years remedied—or both.

This chapter includes the author's short list of primary causes of the 2008 market crises. Although there were more than seven contributing factors, these were the primary causes, or major contributors, that coalesced to result in the 2008 market crises:

1. An incomplete federal response to certain problems that surfaced in the bankruptcy of Enron Corp.

2. The failure of effective regulation (both internally, by means of intracompany controls, and externally, through government regulation) to rein in excessive risk taking and leverage in markets.

3. The development of an unregulated, global, over-the-counter (OTC) derivatives market.

4. The migration of trading from bonds to OTC derivatives due to the implementation of the Trade Reporting and Compliance Engine (TRACE) and the allure of credit derivatives by those who previously traded in the bond and other cash markets.

5. The unrestricted, unmonitored, and reckless use of mortgage origination and private-label residential mortgage-backed securities.

6. U.S. policy that fostered home ownership and government-sponsored enterprise (GSE) mismanagement.

7. Derivatives and structured product accounting practices.

Developing a basic understanding of the causes of the 2008 market crises will help us understand why lawmakers and regulators required certain changes in the derivatives market, and whether the solutions implemented by regulators will prevent later crises.

At least one academic believes that financial services reform legislation enacted in the United States would not have prevented the 2008 market crisis, as reported by the International Financing Review in May 2011:

The Dodd-Frank Wall Street Reform and Consumer Protection Act—and its mandate of clearing as much of the over-the-counter derivatives market as possible through central counterparties—would not have prevented the financial crisis of 2008, according to renowned derivatives academic John Hall … Supposing Dodd-Frank was in place five years ago, and around 70% of DTC derivatives went through CCPs [central clearing parties]. I don't think it would have made a whole lot of difference.1

There are still other important reasons for developing an understanding of the 2008 market crises. Joseph Stiglitz, in his book Freefall, noted:

If we can understand what brought about the crisis of 2008 and why some of the initial policy responses failed so badly, we can make future crises less likely, shorter, and with fewer innocent victims. We may even be able to pave the way for robust growth based on solid foundations … to ensure that the fruits of that growth are shared by the vast majority of citizens.2

IGNORING THE WARNING SIGNS

As the seven causes are discussed in this chapter, it will become apparent that many saw warning signs but no sufficient, collective action averted the market crises until the damage was done. In some cases, responses to past crises, such as the failure of Enron Corp., missed the true causes and dynamics of the market failures, and the stage was set for the subsequent market crises of 2008. In other cases, such as the most recent responses to the 2008 crises, lawmakers appear in many respects to have overreacted. This suggests that lawmakers need to better hear and act upon the next voices calling attention to factors leading to major losses before the next economic calamity takes root, begins to emerge, and causes systemic losses—yet again.

With respect to the 2008 market crises, even as the global economic machine was breaking, it seemed as if many leading economic policy makers and governments in major markets were collectively surprised by the depth of the downturn, notwithstanding repeated, pervasive and persuasive warnings that fundamental problems were literally all over the place. In a study by the Institute for the Study of Labor, the Institute explains:

[F]or much of 2008, the severity of this global downturn was underestimated. Subsequently, leading forecasters, including the IMF and World Bank, made a number of revisions to its growth forecasts during 2008 and into 2009 as the magnitude of the crisis grew. Of course there were some voices that issued dire warnings of a brewing storm, but they were not enough to catch the attention of many who were lulled into a collective sense of complacency in the years leading up to the crisis. Some policy makers, after being caught by surprise at the seemingly sudden appearance of a global downturn, confidently noted that nobody could have predicted the crisis. … Following the events of 2008, particularly the collapse of Lehman Brothers in September, risk-loving banks and investors around the world rapidly reversed their perceptions. … Some commentators even questioned whether American-style capitalism itself had been dealt a deathblow.3

Derivatives have long been a source of significant concern as a destabilizing force for the financial system and for the global economy. Some say that in a February 21, 2003 letter to investors, Warren E. Buffett essentially foretold the 2008 market crises:

The derivative genie is now well out of the bottle, and these instruments will almost certainly multiply in variety and number until some event makes their toxicity clear. Knowledge of how dangerous they are has already permeated the electricity and gas businesses, in which eruption of major troubles caused the use of derivatives to diminish dramatically. Elsewhere, however, the derivatives business continues to expand unchecked. Central banks and governments have so far found no effective way to control, or even monitor, the risks posed by these contracts … derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.4

A recurring pattern in economic crisis and resulting lawmaking is that, unless comprehensive, intelligent, and carefully coordinated, international action results from lawmaking, history will repeat itself. We see glimpses of that—as discussed in this chapter—from the crises and disjointed lawmaking in the United States that resulted after the savings and loan crisis, the fall of Long-Term Capital Management L.P., and Enron Corp. After each of the crises, Congressional inquiries resulted and laws, such as the Sarbanes-Oxley Act5 took legal effect but because the resulting laws did not address, in a careful, coordinated way, many of the derivatives-related issues leading to the failure of Enron and to the 2008 market crises, subsequent losses were experienced by UBS two years later.

MORE THAN SEVEN CAUSES OF THE 2008 MARKET CRISES

Certainly there were more than seven causes of the 2008 market crises, but those discussed here played the most significant roles in causing the greatest economic loss and destruction. None of the causes was the sole or even greatest cause, yet each coalesced over time to create the 2008 market crises, resulting in a global rethink of how our financial system functions, how it is structured, regulated—or not—and how the system must change to prevent future economic crises.

A 10-member U.S. Financial Crisis Inquiry Commission (which is referenced in the pages that follow as the Crisis Commission) published 545 pages of findings in January 2011 that included, in many respects, great disagreement on the causes of the 2008 market crises. The report is comprised of both a majority and a minority argument, with members of the Crisis Commission in the minority stating that their written contribution to the report was limited to nine pages each.6

The Crisis Commission undertook an admirable, Herculean effort to identify the causes of the 2008 crises. Much of what the Commission found and later recorded was, the author believes, on-point and completely accurate.

However, when the Crisis Commission addressed the role played in the 2008 market crises by derivatives, many of the statements in the report published by the Crisis Commission were overstated or simply wrong.

Many of those statements were wrong because members of the Crisis Commission, writing in the majority, apparently could not tell the difference between the derivatives that many companies in the mainstream use every day to manage risk on the one hand, and derivatives that enabled big players like Lehman Brothers and American International Group Inc. (AIG) to pursue excessive risk taking, on the other. One of many statements in the Commission's report illustrates the lumping together of derivatives-related criticisms by the Crisis Commission:

We conclude [that] over-the-counter derivatives contributed significantly to this crisis … when the housing bubble popped and crisis followed, derivatives were in the center of the storm.7

There are, as we will see in our survey of nearly all derivatives in Chapter 10, at least seven categories of derivatives that comprise a glob...

Table of contents

• Cover
• Series
• Title Page
• Copyright
• Dedication
• Preface
• Acknowledgments
• Introduction
• Part One: The Crises That Led to Derivatives Reform
• Part Two: Derivatives Reform
• Part Three: Trading Before and After Reform
• PART Four: Continuing Education
• About the Author
• Index