Governing Global Derivatives

Challenges and Risks

Chiara Oldani

• Publisher: Routledge
• Year: 2016
• Print ISBN: 9780754674641
• eBook ISBN: 9781351932509
• Topic: Politics & International Relations
• Subtopic: Politics
• Index: Politics & International Relations

Governing Global Derivatives analyzes the role of the most important financial innovation of the last two decades - financial derivatives - in a global dimension. The evolution of derivatives, especially Over the Counter (OTC), and the possibility of managing risks tailored to customers' needs, are the basic recipe for the success of derivatives. This book focuses on the role of derivatives from a macroeconomic point of view, considering how monetary theory and policy, fiscal policy and the growth process are affected. It fills a gap by rethinking the way financial markets are considered in the macroeconomy and the transmission mechanism of impulses.

Chapter 1
The Macroeconomics of Derivatives: The Issue of Measurement and Accounting

1. Introduction

Financial innovation, which is the process of creating new financial securities, following customers' needs and exploiting temporary faults in regulation represents the natural evolution of markets, where players are looking for new profitable opportunities and better resource allocation. Innovation exploits the imperfections and inefficiencies of markets, avoids regulation, and gives rise to extra profits, specifically because at the beginning there is no patent protection. Innovation is the way animal spirits emerge on the market, and profits are the premium earned by the innovator.

Imperfections are inevitable ingredients of financial instability and innovation, but while instability usually has disruptive effects, innovation is part of a creative process. "Although difficult to define precisely, financial instability, in my view, connotes the presence of market imperfections or externalities in the financial system that are substantial enough to create significant risks for real aggregate economic performance" (Ferguson 2004). This definition of instability synthesizes its main ingredients, and stresses the main negative drawbacks: financial innovation should not create significant risks if is a positive force in the development process and does not introduce instability.

An important class of innovation is that of derivatives. Derivatives were introduced early in the history of international trade, in the ancient Middle East, to hedge commodity price risks, and today are traded in world stock exchanges, or over the counter (OTC). Exchange-traded (ET) derivatives have a well-established and solid market procedure and settlements system; OTC transactions are unstandardized and opaque, but not necessarily riskier. The Bank of International Settlements (BIS) is the international institution in charge of measuring OTC transactions, and plays a very important role in the disclosure of such opaque transactions.

The economic and financial characteristics of derivatives are fundamental to the understanding of the functions they play in investors' portfolios. The measurement of transactions -ET and OTC- is a necessary methodological premise to their valuation, and their relationship with the market, agents and the economy. The accounting of derivatives, following the introduction and application of the International Accounting Standard (IAS) No. 39 and the Financial Report Standard (FRS) No. 13, is inspired by fair value.

Derivatives are not considered to create new risks, but they can hide existing risks, and the knowledge and awareness of risk is fundamental to maintaining stability. Most cases of derivatives losses are basically due to mismanagement but this does not justify the lack of comprehensive statistics about the phenomenon.

2. A brief history of derivatives

Derivatives contracts are as old as trade. Swan (1999) dates first commodity futures back to ancient Mesopotamia (about 1700 B.C.E.); these contracts were very similar to those traded on stock exchanges nowadays. They were traded in temples, and priests acted as traders or brokers, while trading rules were based on religious principles (i.e. honor, faith, good management). Temples acted like modern exchanges, and the success of the deals was guaranteed by the religious organization, providing the necessary facilities (e.g. grain houses) and insurance against fraud. Ancient Mesopotamian derivatives were basically commodity contracts, since agriculture represented most of the economic activity in these areas. Settlement was possible using precious metals (silver, gold) or farming goods (barley, sesame, spices).

Private transactions were allowed and communities of local or foreign merchants governed by separate laws were a common feature of the Mesopotamian system, still present in the Middle East after the Crusades. Private transactions can be thought of as being non-standardized, similar to OTC contracts nowadays.

As merchants' needs increased, written rules started to be produced, the most famous of which is the Hammurabi Code. The kingdom of Hammurabi lasted between 1792 and 1750 B.C.E, and introduced two important developments for derivatives. The first was the possibility of future delivery, and the second the transferability of rights under a contract of sale. Codes and rules were ancient but not primitive, as Swan observed, and the introduction of written contracts avoided misunderstandings due to different languages and cultures. Mesopotamia was a very modern society, and private property was safeguarded. In a number of cuneiform written texts reporting contractual obligations, there are several sophisticated concepts that are still found in the law of trade. The Mesopotamian policy actively supported the creation of a sound trading system to support the production and trade of commodities and sustain the growth of the region.

A very distinct approach was that of the Egyptians, who did not recognize the strategic importance of private property, and this resulted in very slow development of the market economy. Rather like the Egypt of the Pharaohs. Greek culture was inspired by an undeveloped model of growth, where Greece bartered luxury goods, and conquered to obtain the others. Production models and incentives did not feature in the modern-style Greek democratic system.

The Roman Empire was centralized, and the city of Rome attracted most commodities produced in Europe (grain, clothing, or building materials). Although it was not forbidden, there was little room left for private free trade. The economy was based on agriculture and the army, and trade played a very minor role. The unified coinage and banking system represented a unique example of financial sophistication, unfortunately not supported by real economic development. The contribution of the Romans to derivatives trading, like many other things, lay in the juridical and legal system that governed it; however, the original Roman law system was quite slow and difficult to apply. It improved only after centuries, following the development in commerce and trade throughout the Mediterranean by the Italian cities of Amalfi, Naples, Venice and Bari during the ninth century. The use of derivatives became so common that at that time the municipal public deficit started to be funded through bonds and swaps¹.

The Champagne Fairs during the Middle Ages, and Italy during the Renaissance, were the European centers of private trading, including the development of contracts, payments' systems and commerce. On the other hand, the Church of Rome, "the promoter of the Roman law", was the sole entity allowed to regulate commerce, and was the "largest producer of commodities in Europe", since it was the largest landowner (Swan 1999, 124). After the seventeenth century, Northern Europe (UK and Holland) and North America (USA and Canada) were the most important centers of commodities or financial trade and promissory buying and selling. Derivatives markets were founded in Japan in the seventeenth century, and in Chicago (US) in the nineteenth century. Today, the latter is still the world's most important and biggest derivatives market.

While the trading of commodity derivatives still plays a relevant role in the world market, financial contracts involve more resources: the notional amount of commodity derivates reached US$7 billion, while OTC-only financial derivatives report US$370 billion.

Table 1.1 Commodity derivatives by instrument and type*

Notional amounts outstanding at end June 2007 (in millions of US dollars)
Instrument/counterparty	Gold	Precious metals	Other commodities (other than gold)
Forwards and swaps	140,927	42,245	3,404,656
Options sold	118,141	30,638	2,023,892
Options bought	230,012	25,121	2,439,400
Total options	284,608	45,581	3,648,655
Total contracts	425,535	87,825	7,053,311
Gross market value
Total contracts	47,181	6,116	617,112

Note: * While data on total options are shown on a net basis, separate data on options sold and options bought are recorded on a gross basis, i.e. not adjusted for interdealer double counting.

Source: BIS Derivatives Statistics, 2007.

While derivatives, transactions involving uncertainty, are as old as commerce, I will show in this chapter how modem financial markets have exploited their characteristics. This was especially true after the 1970s, when capital controls were removed, fixed exchange rates were abolished and oil shocks were hitting the world economy. Moreover, the pricing theory of derivatives was developed in the 1970s, and the study on Brownian motion and Ito's work on stochastic processes led Black and Scholes to obtain the option's pricing formula.

Today's worldwide regulated markets, based on the year they were founded, are summarized in the following table. However, alliances and mergers, especially over recent years, make this far from straightforward. It is relevant to note, that Europe and the US show very different attitudes toward financial markets. In the US. specialized financial markets are popular and exploit international synergies, like the New York Stock Exchange (NYSE). In Europe, national borders, local interests and different legal rules make a single financial market still a very difficult goal to achieve, and the City of London dominates in terms of trading and liquidity.

Table 1.2 World derivatives exchange traded markets

Country	Market name	Starting year	Main underlying
France-US-UK-DL-NDL-BL-PT-IT	NYSE EuroNext*	2001	All
Germany-Swiss	EUREX	1990	Bonds, Repo, IR*
UK-Italy	LSE	2007	All
Singapore	SGX§-SIMEX°	1999	IR*, Stock Index
USA	CBOT	1849	Shares, Stock Index
USA	CBOE	1973	shares
USA	CME°	1970s	Commodity

Note: * IR = interest rates. ** EuroNext.liffe is the international derivatives business of EuroNext, comprising the Amsterdam, Brussels, LIFFE, Lisbon and Paris derivatives markets. It was formed following the purchase of LIFFE (the London International Financial Futures and Options Exchange) by EuroNext in 2001. EuroNext.liffe is the world’s leading exchange for Euro short-term interest rate derivatives and equity options. It also offers a greater choice of derivatives products than any other exchange: it offers futures and options on short- and long-term interest rate products, on equities, indices, government bonds and commodities. § The SGX is the result of the merger between the SIMEX and SES (Stock Exchange of Singapore) which took place in 1999. Derivates started to be traded in the ‘80s at SIMEX. ° They form the GLOBEX® Alliance which is the world’s first electronic trading network for futures and option contracts. It enables the EuroNext Paris SA, the CME and the Singapore International Monetary Exchange (SIMEX) to trade each others’ contracts around the clock.

Source: Markets’ own websites.

Since the start of 2006, a merger and takeover wave among stock exchanges has been changing the structures of alliances, in turn widening the opportunities for investors and operators at a cross-border and transatlantic level. Examples of this include the various offers of friendly mergers among NASDAQ, the London Stock Exchange, EuroNext, the New York Stock Exchange (NYSE), Deutsche Borse and the Milan Stock Exchange. This aggregation process also involves exchange-traded futures markets².

Since monetary union, the European banking industry has been concentrating on working trans-nationally, and across different sectors (retail, investments, and so on). Aggregation in the financial sector, according to the HausBank system (i.e. the German-style financial structure where a bank is a retail, commercial and investment player, and eventually enters the insurance market), is aimed at differentiating risk and returns. However, the experience provides contrasting results in performance, depending on the business sector, country, and the contingent business cycle. This wave, together with the kspread of financial innovation, can modify the allocation of risks, concentrating them in the hands of a few market players, and it might alter the effectiveness of monitoring and supervision. The absence of a homogenous financial regulation is an obstacle toward complete financial integration.

Over recent years, financial institutions which specialize in OTC transactions have attracted the attention of large banks. Acquiring these f...

Table of contents

• Cover
• Half Title
• Title
• Copyright
• Contents
• List of Figures and Graphs
• List of Tables
• Note on the Author
• Preface and Acknowledgements
• Series Editor Preface
• List of Abbreviations
• Dedication
• 1 The Macroeconomics of Derivatives: The Issue of Measurement and Accounting
• 2 Derivatives and Monetary Policy: Global Stability
• 3 Derivatives and Fiscal Policy: Risks and Hazard
• 4 The Theory of Investments and Derivatives: The Frontier of Economic Analysis
• Summary
• Challenges in Governing Global Derivatives
• References
• Index