Derivatives 101: Over The Counter vs. Regulated
From the beginning of the financial crisis, government and economists have repeated many times that the real cause of the crisis was the Derivative Market and more particularly the un-regulated, Over The Counter, market for derivatives. The OTC for derivatives has been growing in volume for years to attain a cumulative of more than $700 trillion in 2008. It is easy to see why it could be important to bring more transparency to this market where many speculators and greedy investors don’t hesitate to enter given the lack of supervisory activity by the SEC or any other institution.
Many governments around the world have expressed their concerned like the US government when Mr Geithner, The US Treasury Secretary, said in a recent testimony before the House Financial Services Committee and House Agricultural Committee: “Although derivatives bring substantial benefits to our economy by enabling companies to manage risks, they also pose very substantial challenges and risks. The lack of transparency in the OTC derivative markets combined with insufficient regulatory policing powers in those markets left our financial system more vulnerable to fraud and potentially to market manipulation." I am also a believer that more regulation will bring more sustainable growth in the Future. Recently the German Chancellor, Angela Merkel, explained that in her opinion: “there could be no longer blank spots where regulations don’t apply in the wake of the financial meltdown”. She was also pointing out a greater regulation for hedge funds and credit agencies that are said to have amplified the effect of the financial crisis.
The OTC for derivatives is very complex and covers a large variety of products like Forex, Commodities, Debt Swap (fix vs. floating rate) and many other financial instruments. Given the complexity and the size of the market it will definitely be a daunting task to change the regulatory system there. Government will also face a strong resistance from companies around the world that are not in the business of speculation. But why will there be more resistance?
Most companies around the world, from the smallest to the largest have used at least once in their life the OTC market. The OTC, here the Forward Market, is more flexible and more appropriate than the Future Markets, a market run by companies like the Chicago Mercantile Exchange. It sounds complicated but actually it is very simple. Here I am not talking Options markets, which are another story. I am talking about a market where players can protect themselves against many different business risks, like a drop in corn prices, a rise in oil price (often referred as the Oil Future, which touched $147 in July 2008), or the strong depreciation of a currency (like the Russian rouble that dropped more than 40% last year). In a sense Forward and Future are the same type of product.
In the Forward contract there are two counter parties agreeing to buy/sell a product at a certain price in the future (3 months, 6 months, 1 year …). The buyers/sellers as a result know exactly how much money it would get from selling/buying its corn, oil, orange juice … Companies can as a result have more certainty about their future cash flows. The Forward market is often used over the Futures market because it does not require up front money flows and it is also possible to create a product that covers exactly the specific risk of a company (given the company finds a buyer/seller for such Forward). However, there is no supervisory regulator in this market and it is possible that one of the counter party defaults if the market price is not going its way.
Future markets are regulated. It means that there is an entity, like the CME, that follow every transaction and that provides liquidity and insurance in case of default. The contracts are standardized, which is often an issue because companies prefer to have a financial instrument that can cover 100% of their risk and not only a fraction of it. At the same time standardized contracts help bringing more liquidity to the market and reduce the risk of default for investors as now you can buy/sell the Future at anytime in an open market and you don’t have to know your counter part. Another negative (or positive) with Future are margin requirements. Even if the cash inflow/outflow will be made in the future for both buyer and seller, the regulator requires a % of the total contract as a depository. At the end of every trading day, price are settled and if the prices drop/increase is greater than the margin then the regulator asks the counter part to add more money to bring its margin back up (it is known as Margin Call).
I view Future markets are the better of the two market as I see more transparency and less risk of default. However, companies around the world have argued that Future markets force them to set aside money for margin call, money they could use for investment. As a result they would either reduce their investment spending or simply borrow more money and become more risky companies as a result. It is difficult for me to see the real impact on the treasury of companies. It is possible that the smaller companies would encounter some changes in their investment spending if tighter regulations are to be acted. It is certainly one of the many issues regulators and governments will have to think about in the coming months.
However, the recent past as shown us that if financial markets remain the way they are, we will most likely experience many other financial crises in the future. Investors are greedy and have short memories. What matters is how much money you make no matter how you make your money. Goldman Sachs has released very strong results a few days ago. The company went back to its successful strategy of making money with their trading desk. Should we welcome such strong earning results or should we be concerned? It is up to you and the market to decide …