From The World in 1994

Join the derivatives club

From The World in 1994


For regulators already worried stiff about the obscurity of financial derivatives there is worse to come. Developing countries–at least the more advanced ones–are beginning to have access to the so­phisticated instruments and techniques that have become the jazzy side of finance in the industrialised world's centres. Barriers to their use–lack of knowledge, wariness, government restrictions and, most important, low credit-worthiness–are fast disappearing. As the area they are trying to patrol spreads (and it will spread greatly in 1994), regulators will trail ever further behind the markets. It's a humiliating prospect for them.

No other development in modern times has fazed financial regulators as much as the derivatives cult, the explosion of futures, options and swaps in currencies, equities, interest rates, commodities and so on, whose value is determined by the underlying cash markets. Building from yesterday's simple hedging–such as forward cover on foreign exchange–Wall Street's bright young "rocket scientists" (a more alluring description than mathematicians) now devise customised, over-the-counter contracts to meet any requirements, to swap anything into anything else, then to hedge the swap exposure.

They have given derivatives a life of their own; some users forget about the original purpose altogether, seizing opportunities to enhance yields or to exploit inefficiencies between markets. And what was the exclusive province of advanced countries is now being invaded by the newly industrialising ones, vastly extending its frontiers.           

Inevitably, you will say. But hastening the process is the unexpectedly untidy way the world economy is growing. Polarisation into currency blocks is still the logical evolution, but it looks much further down the road than it did a few years ago. This is not just because the breakdown of the EMS has diminished the likelihood of a single European currency this century. No less significant, more and more developing countries are experimenting with floating their currency rather than anchoring it to a key industrial one, usually the dollar, or a basket of currencies. And that alone means more complicated risk management.

Brazil, Costa Rica, India, Indonesia, Paraguay, Peru and Venezuela are just some of the developing countries whose currencies now float but didn’t five years ago. The move may have been forced but–surprise, surprise–it works. What’s more, the high priest of exchange-rate arrangements, the International Monetary Fund, says the a priori arguments against floating for developing countries are not valid. Notably, too, the Fund has changed its advice to the states of the former Soviet Union, encouraging them to introduce their own currencies rather than remain in the rouble zone. And China plans to unify its exchange rates in 1994, in preparation for bringing a potential heavyweight into the splintering currency markets.

Then there has been the astonishing growth of emerging stock markets, with institutional investors increasingly committed to them. Helped by recession in industrial countries and the dropping of barriers to investment in the third world, these markets have already attracted some $50 billion of international portfolio investment. Some will be among the best performing equity markets in 1994. But others will be among the worst performers. Such extremes invite insurance companies and pension funds to seek equity derivatives in these markets.

Not in vain. Expect a leap in activity in derivatives related to emerging stock markets. Increasingly, products such as index-linked contracts that provide a substantial proportion of market upside and no downside risk will be on offer, together with index warrants and options.

This is only the beginning. Newly industrialising countries and the new market economies are looking for access to more sophisticated derivatives to help their firms and financial institutions cope with today’s volatility in exchange rates, interest rates and commodity prices. Giving them a helping hand is the World Bank’s private-sector arm, the International Finance Corporation. It may do no more than provide know-how, but sometimes it mobilises international banks as rick-sharers. And it always has an eye to bringing hedging instruments into local capital markets.

So expect development of domestic futures and options exchanges in countries ranging from Hungary, Russia and China to Mexico, Chile and Brazil. The latter, in particular, has already made a good start. The Brazilian futures market offers contracts in dollars, commodities, interest rates and a stock index–and option contracts involving the local currency are also available. South Korea has still some way to go. But eventually the Brazils and Koreas of this world will be among the major players in foreign exchange and other risk instruments, with their own banks and securities firms participating both as traders and end-users.

Cause for rejoicing if such countries can fulfil their own financial requirements. But spare a thought for the regulators. Regulators are in a terrible state of indecision. Nobody can accuse the Federal Reserve chairman, Alan Greenspan, of having a lazy mind, but here is his dilemma. While he accepts that derivatives should “allow banks to better manage risk and so should help to insulate the payments system from financial and real shocks,” it is “by no means clear” whether financial market innovations “have increased or decreased the inherent stability of the financial system.” His conclusion: “Central banks must find ways to assess and limit systemic risk without losing the benefits of these new markets.”

But how, Mr Greenspan? If experience is anything to go on, controls and restrictions to lessen systemic risks are not the answer; they only stifle economic growth. Politicians, enraged when so-called “speculators” win, may call for them but they will be unwise to bring them back. If regulators overdo their prudential supervision of banks, this, too, could strangle legitimate risk-taking. Over time, perhaps by 1996, they will introduce new capital standards for banks and securities firms covering some market risks, but these will not be tough enough to dispel fears of a breakdown in the entire system.

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