While my posts usually discuss some aspect of being a product owner, today I wanted to share my thoughts on an issue that faces the industry in which I currently work. As part of a risk management firm that provides both technology and advisory solutions to companies around the globe, I help clients understand, utilize, and price financial derivatives. And derivatives have gotten a very bad rap in the current financial crisis.
Now I am not going to try in this post to unpack all of the issues around the use and misuse derivatives or about whether and how they should be regulated. If you want to read some good stuff about that check out this link to some great articles, webinars, and comment letters (https://www.chathamfinancial.com/derivatives-regulation/). My general feelings on this issue are the ones any regular readers of this blog might expect: In truth it’s not that simple.
Have some firms used complicated and opaque financial derivatives to disguise their true financial health? Absolutely. Have some derivatives marketers taken advantage of the complexity of these instruments to make an unfair profit off of uninformed clients? Unfortunately yes. Do some companies use the leverage available through derivatives to make massive gambles on foreign exchange rates, interest rates, credit, or other market forces – only to cost their investors major losses when these bets go against them? Certainly.
But many other firms use derivatives not for speculation or manipulation but simply for prudent risk management. Companies worried about fluctuating prices for basic commodities (like fuel for trucking and airline firms or copper prices for cable-making companies) use derivatives to lock-in known prices for these inputs to their process so that they can concentrate on producing a good product or service at predictable prices. Real estate firms and many smaller companies worried about potential rises in interest rates on their floating-rate debt use derivatives to ensure that they won’t face insurmountable interest payments in the future.
In many ways the whole conversation about derivatives reminds me of this clip (you can guess where it comes from): http://www.youtube.com/watch?v=zrzMhU_4m-g
The logic in this argument isn’t hard to follow. Here’s a woman who looks like a witch. As everyone knows, witches are burned and therefore must be made of wood. Wood floats just as ducks float. Which means that if the woman weighs the same as a duck then she must be made of wood and therefore she must be a witch.
The logic of derivatives regulation follows a similar progression. Some firms have used some derivatives for rampant speculation or flagrant dishonesty. Therefore anything that looks like a derivative (no matter the reasons why a firm might be using it) must be bad and should be subjected to stringent regulatory oversight. Fortunately as the actual rules are being finalized there are some needed exemptions being carved out for ‘derivatives end users’ – firms that truly use derivatives to manage risk rather than to speculate on rates. But too often (in my estimation anyway) both the media and regulators are portraying every use of derivatives as bad without acknowledging the nuances.
The proper role of regulation and consumer protection for the derivatives industry is a complex issue, and vilifying all derivatives and derivatives users surely doesn’t help advance real solutions. In truth, it’s not that simple.