By Emma Trincal, Senior Financial Correspondent
Friday, February 16, 2007 11:01:55 AM ET
OMAHA, Neb. (HedgeWorld.com)—The huge size of the derivatives market has many predicting financial calamities. Doom-and-gloom scenarios abound from pundits, from Main Street voices, from Congress, regulators. And because hedge funds are heavy participants in this large and complex market, they are part of the bleak picture painted by the Cassandras. Warren Buffet in 2003 coined the expression "financial weapons of mass destruction" to characterize derivatives. And earlier this month, the U.S. Congress pledged to issue a report on the subject by June 27, responding to concerns by lawmakers about the potential dangers of those instruments Previous HedgeWorld Story.
One latest example of such pessimistic calls is the recent warning issued by Roland Manarin, president of Omaha, Neb.-based Manarin Investment Counsel and portfolio manager of Lifetime Achievement Fund, a fund of mutual funds. Mr. Manarin, named by Barron's as one of America's top wealth advisers, has also been since 1986 the host of "It's Your Money," one of the Midwest's longest-running financial radio shows.
"While hedge funds do represent a true danger to financial markets and the public needs to be aware of the high risks, the real focus ought to be on the outrageous amount of derivatives being traded," Mr. Manarin said.
In an interview, Mr. Manarin worried about the size of the derivatives market, which he said represents nearly $300 trillion in notional value, a number nearly 25 times greater than the U.S. gross domestic product ($13 trillion.)
According to the International Swaps and Derivatives Association, the notional size of the market is indeed huge: $283 trillion as of June 2006, the latest available statistic. The December figures will be released in the spring. The ISDA defines derivatives as financial securities whose value is derived from another "underlying" financial security. Options, futures, swaps, swaptions and structured notes are all examples of derivatives securities.
Continuing his anti-derivatives thesis, Mr. Manarin said that, "Most often derivatives are used to hedge against risk but are also used by speculators hoping to make big bucks. When you enter the derivative bet, you place a huge amount of assets with a tiny amount of money, which is the major reason that these financial instruments are so dangerous."
Mr. Manarin cited derivatives as the main cause of major financial crises such as the stock market crash of 1987; the collapse of Barings Bank in 1995; the Asian market crisis in 1997; and the fall of Long-Term Capital Management. "The major banks are among the largest players in the derivatives market and [they make] their bets with money created from nothing. A 4% decline in the nominal value of traded derivatives equals to our GDP for a year, so watch out!" Mr. Manarin said.
But is if fair to blame derivatives contracts for all past financial disasters? The remarkable growth and complexity of this market also has resulted in a great deal of confusion and misconceptions, say some derivatives experts in rebuttal. To them, derivatives basically play a positive role in stabilizing the economy and reducing risk.
"If it's a huge market, it doesn't necessarily mean it's going to be the next explosion," said Willa Bruckner, member of the Financial Services and Products Group at Alston & Bird, a New York law firm. For instance, she said that the collapse of Barings was "less of a derivatives issue and more the result of an internal control issue." She said that the Asian crisis in 1997 was provoked by problems inherent to the Russian economy, not derivatives.
"Surely derivatives products have the potential of magnifying losses but they also offer the possibility of hedging losses and reducing risk by slicing risk into pieces," she said. "If properly managed and properly allocated to a portfolio, derivatives can reduce risk. It's no different than nuclear energy: It's a wonderful tool if used properly. If not, it can be incredibly destructive," she added.
The major banks have made significant progresses in clearing derivatives trade backlogs, she said, which proves that dealers instead of being the problem are "part of the solution."
"Look at Amaranth," Ms. Bruckner said. "It was a much bigger loss than LTCM, but the impact was much smaller because we now have better risk management of derivatives contracts," she said.
Finally, she pointed to the misleading aspect of "notional" figures. The notional in derivatives jargon refers to the amounts of the underlying assets traded via derivatives instruments.
Taking the example of $1 million of notional in interest rate swaps, she said that if two parties trade a derivatives contract that represents 6% of the notional, they're actually exchanging $60,000. "The biggest piece of this derivatives market is in interest rate swaps where the actual transfer of cash is much smaller than the notional," Ms. Bruckner said. She said that losses can be contained and that the frequency and the size of the losses tend to be smaller as the market evolves. Ms. Bruckner conceded that risk is not totally eliminated and that a big loss could occur in the market, but the odds are slimmer. "And this is a fact of life. You can't get away from risk. If you remove the risk, you have no game," she concluded.
Derivatives research expert Dushyant Shahrawat at TowerGroup, a research firm based in Needham, Mass., also disputed Mr. Manarin's claims. He said that "Barings was not a derivative problem. It was renegade trader in a firm with bad risk management in place. And the 1987 crash had nothing to do with derivatives. It was due to speculation."
While Mr. Shahrawat did not rule out potential risks, he stressed his contrarian view on risk: "We don't think the risk is centered around large banks. Instead, we think risk comes from hundreds of thousands of small companies," he said.
"Everybody gets excited about the notional value. You can't see it out of context. What you've got to look at is how derivatives are being utilized. A few years ago, people were using derivatives for speculation. Today, it's mostly used as a risk reduction tool," said Mr. Shahrawat.
ETrincal@HedgeWorld.com
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