Derivatives Industry Fights Image Problem : Finance: Complex trading raises concerns about possible new banking-industry problems. Few understand the hybrid securities, whose value is ‘derived’ from other assets.
It’s depicted in financial journals as a wild three-headed dragon or a slimy beast bursting out of a bank’s computer room. One congressman wonders if it may lead to another savings and loan crisis. Few outside the banking world understand it.
The derivatives industry, as they say in the public relations world, has an image problem.
This worries executives of banks and brokerage firms, who have responded with a detailed campaign to educate members of Congress about the fast-growing market of exotic financial contracts and assure them that derivatives deals won’t be the latest in a string of banking industry boondoggles.
The stakes are considerable. Derivatives are a significant source of profit for major financial-services firms and frequently are used by corporate treasurers to reduce their financing costs by limiting risks from surges in foreign currencies and interest rates.
Ill-conceived regulation, bankers say, could restrict participation of U.S. banks and brokerages in the market and make them less competitive internationally.
The industry’s education campaign, led by the trade group International Swaps and Derivatives Assn., or ISDA, faces tremendous obstacles: There is substantial confusion about the basic definition of derivatives as well as the size and credit risk the market represents.
“I think there is a large problem with getting everyone in the same boat,” said Jeffrey Seltzer, managing director for derivatives products at Lehman Brothers.
Derivatives are a kind of hybrid of securities and commodity futures contracts, and the overall market doesn’t fall into a particular regulatory body’s jurisdiction. Their value is linked to, or “derived” from, another asset such as a basket of stocks, a foreign currency or barrel of oil.
In their purest form, derivatives can help companies save money by limiting losses from sudden shifts in interest rates and foreign currency values. This is the same concept of hedging that leads farmers to use futures contracts to get a predictable price for their crops.
Attempting to make the arcane market more understandable, the industry is bringing its customers to Congress. At McDonald’s Corp., for example, franchise owners use derivatives to cap interest rate movements, which cuts their borrowing costs so they can deliver Big Macs and fries cheaply to hungry consumers worldwide, spokesman Chuck Ebeling said.
“We’re not involved in the derivatives area for the purpose to trade in derivatives, but for a means to keep the prices for our franchises down,” Ebeling said.
The term “derivatives” encompasses a huge array of financial products: Standard & Poor’s 500 index securities, such as those traded on the American Stock Exchange, are derivatives, for example.
It also encompasses more complex, individually tailored deals, such as swaps, which are agreements between two parties to exchange cash flows according to a prearranged formula.
One key mistake in discussing derivatives: Some people don’t distinguish between derivatives traded on exchanges, which have certain credit guarantees against default, and those created in the over-the-counter market, which lack such guarantees.
The size of the over-the-counter derivatives market was $4.7 trillion by the end of 1992 in terms of the overall value of the contracts, which bankers call the notional principal amount. But the actual credit risk to banks and brokerages is much less--perhaps 1% to 3% at most, or $144 billion at the end of 1992, the ISDA says.
Banks and brokerages disclose little about their derivatives business. The lack of disclosure breeds suspicion by analysts and regulators, some of whom wonder if banks are making large speculative bets.
Banks deny they are speculating and say their derivatives business is difficult to separate from foreign exchange and bond dealings. A majority of their activities is at customer request, they say.
“The growth in the activity has more to do with Main Street than Wall Street,” said Mark Brickell, a vice president at J.P. Morgan and former ISDA chairman.
Seltzer said the industry has clearly heard the wake-up call from regulators and is closely monitoring its credit risk. Officials say they have done a good job.
They also point to the stability of derivatives during the 1987 stock market crash, the European currency crisis and several huge bankruptcies of big swaps customers, such as Olympia & York Developments Ltd. and Bank of New England.
That doesn’t mean people aren’t getting burned. American International Group, the giant insurance company, took a $90-million, third-quarter special charge that according to published reports was due to derivatives losses.
Seltzer said the derivatives industry is pleased by the market’s continuing strength during financial turbulence elsewhere.
“The market has been stress-tested and the market has performed well,” he said. “And that is good, but you shouldn’t be complacent about it. You have to be vigilant.”
The industry’s efforts appear to be paying off. Rep. Henry B. Gonzalez (D-Texas), chairman of the House Banking Committee, asked recently if banks were using derivatives “to engage in casino-like gambling activities.” Gonzalez raised the specter of the savings and loan crisis, but didn’t call for outright restrictions.
