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The Perception on Financial Derivatives: The Underlying Problems and Doubts

Chapter 1
The Perception and Myths on Financial
Derivatives: The Underlying Problems and
CHAPTER 1: The Perception of Financial Derivatives: The Underlying Problem and
This opening chapter introduces derivatives and the debates surrounding their use. It
highlights the scope for this book, provides the objectives, the intended contribution,
presents the problem and discusses some questions and curiosities surrounding their use.
Moreover, previous studies carried out on derivatives are summarised herein.
1.1 Overview
Edington, (1994), see the opinions on derivatives as two opposing camps:-
“those who embrace them as the ‘Holy Grail’ of the new investment era, and those who
denigrate them as the financial Antichrist”. As this quote suggests, there are many
conflicting views and opinions on derivatives and their use. Derivatives are seen either as
useful instruments or as a complete waste of time and money (Dodd, 2002b). As defined by
Hull (2008), derivatives are any “financial instruments that derive their value from the
value(s) of other, more basic, underlying variables.” The underlying can be anything, such
as, for example a financial asset or a rate, with payments that are linked to an index, the
weather in a specific region, or the profitability of selected companies (Stulz, 2005).
Stulz (2004), in his paper ‘Should We Fear Derivatives?’ specifies “two types of
derivatives: plain vanilla and exotic.” Plain vanilla derivatives are forward and futures
contracts, swaps, options, or a combination of these. Exotic derivatives are all other
remaining derivatives. These will be described in more detail in the second chapter of this
‘A Chronology of Derivatives’, by Chance (1995), focuses on the history and
development of derivatives. He notes the start of derivatives came about at around 580 B.C.,
“when Thales the Milesian, purchased options on olive presses and made a fortune off a
bumper crop in olives.” According to Chance, in 1700B.C. Jacob (Bible, Genesis chapter 29),
“purchased an option, at a cost of seven years of labour, that granted him the right to marry
Laban's daughter, Rachel.” Chance identifies key historical moments in the derivatives
development: the very first derivatives exchange was the ‘Royal Exchange in London’, were
forward contracts were carried out. The first "futures" contracts, are said to have been
executed in the 1650s, in Osaka on Japan’s Yodoya rice market. Chance notes that the next
most important “event happened with the formation of the Chicago Board of Trade in 1848.”
In another paper, ‘Demystifying Financial Derivatives’, Stulz (2005) notes that until
the 1970s the derivatives markets were not always so large. However, the changes in the
economic climate and the advances in the pricing methodologies of derivatives led to
spectacular growth. During that period, the instability of “interest rates and currency
exchange rates increased sharply, making it crucial to find ways to hedge the relative risks
more efficiently. Meanwhile, deregulation in a variety of industries, along with soaring
international trade and capital flows, added to the demand for financial products to manage
risk.” According to Stulz (2005), the development, in the early 1970s of the Black-Scholes
formula and technology innovations which enabled faster and more efficient management of
computations, stronger network and communication infrastructures, changed trading of
derivatives drastically. Thereafter, financial engineers could build new derivative products
and find their value more easily.
However, the market for derivatives and their use has subsequently mushroomed, and
according to the Bank for International Settlements Quarterly Review (December 2009 and
March 2010), the global growth in the first half of 2009 of notional amounts of all types of
over-the-counter (OTC) derivative contracts mushroomed to a size of US$605 trillion at the
end of June 2009. Exchange-traded derivatives on the other hand, “measured by notional
amounts, went up by 5% to US$444 trillion between October and December 2009, that is,
22% higher than the trough in the first quarter, but still well below its peak in early 2008
(US$690 trillion).” However, the latest statistics show that the gross market value of
outstanding OTC derivatives contracts fell to its lowest level since 2007, that is $11 trillion at
end 2017. On the other hand, the share of centrally credit default swaps (CDS) rose to 55% at
the same date. In terms of notional amounts of outstanding OTC derivatives contracts, there
has been a fluctuation in a range of $490 trillion and $550 trillion between 2015 and 2017.
(Bank for International Settlements, 2018)
Therefore, there is a considerable need to further understand, and contribute to the
scholarship on derivatives. Moreover, the large and variable market size necessitates controls
that are constantly kept up to date in order to prevent a potential global financial crisis started
by this instrument.
As we shall see in the next chapters, experience has indicated that derivative products
have transformed the way firms view financial risk and mitigate it. It is no longer relatively
simple and risks are changing continuously with innovation. Risks are no longer nationwide
but global and the internet and other fast communication channels have further complicated
the issue. In her article, ‘Are Derivatives Financial "Weapons of Mass Destruction"?’ Simon
(2008), explains that although derivative instruments have been used to hedge risks that were
previously left open, there are still those who are sceptical about using these instruments. As
the Group of Thirty (G30) (1993) note, users from “both inside and outside of the financial
industry, remain uncomfortable with derivatives activity.” Moreover, the latest survey by the
Bank for International Settlements (2009) suggests that there is widespread employment of
derivatives with adequate risk management systems. Nevertheless, not all firms are immune
to derivatives misuse.
In Philippe Jorion’s (1995 p.4) ‘Big Bets Gone Bad’, he recites the words of a Wall
Street wise man Felix Rohatyn, who described derivatives as “financial hydrogen bombs
created by 26 year-olds with computers.” He notes the description given to derivatives “a
monstrous global electronic Ponzi scheme,” by Henry Gonzalez, former House Banking
Committee chairman. In a March 1995 broadcast of the CBS TV show 60 Minutes,
derivatives were depicted as “too complicated to explain but too important to ignore.” This
show suggested that derivatives are “highly exotic, little understood and virtually
unregulated. Some people believe they are so unpredictable they could bring down the world
banking system” (Jorion, 1995 p. 4).
Hull (2008) highlights that the perception of derivatives as inherently bad financial
instruments which have led to large financial failures of companies and government
institutions. However, according to Cochran (2007), the understanding of the concept of
derivatives“which most economists view as a positive innovation that emerged over the
past 30 years is a predominant factor in the global financial markets. Since many
derivatives involve cross-border trading, ‘the derivatives market has brought increased
international financial fragility and the attendant need for greater supranational governance of
the instrument” (McClintock, 1996).
Becketti (1995) notes the popular belief that firm-specific risk and systemic risk are
increased by derivatives use and perceived to have threatening effects on both the real sector
and the financial system. Firm-specific risk includes “credit or default risk, legal risk, market
and liquidity risk, operating or management risk.” Systemic risks entail “greater competition
between banks and non-bank financial institutions, greater interconnectedness of financial
markets, increasing concentration of derivatives trading, reduced disclosure of financial
information through off-balance sheet activities such as in the case of Enron, and financial
and telecommunication innovations that have intensified reactions to market disturbances.”
Becketti (1995).
Warren Buffett (2003) as noted by Simon (2008), describes derivatives in the
Berkshire Hathaway Inc. 2002 Annual Report as being “financial weapons of mass
destruction and contracts devised by madmen”. An article by Das (2006), ‘Traders, Guns and
Money’, quotes the Financial Times (n.d) as highlighting that “ever since Warren Buffett
memorably described derivatives as ‘financial weapons of mass destruction’ there has been a
thriller waiting to be written about them.”
Following the nnumerous cases of losses were derivatives have been use, the question
on whether derivatives and there markets are the real culprit that brings about large failure
and the losses by companies and government entities. Some of these cases are summarised in
the following chapters. Table 1.1 below lists a summary of some of the renowned trading
losses ever, highlighted in literature. It demonstrates the troubles that these derivatives
instruments are perceived to have brought to the economy and the losses derived from their
use. All, except for a few (such as Daiwa Bank in 1995), have involved the use of, and
trading in, derivatives. In addition, just to give a perspective of the losses we added the
percentage of the total losses as summarised in this table. Moreover, Barth et. al., (2012), note
in their article, ‘Trading Losses: A little perspective on a Large Problem’ when seen through
the lens of relative size (relative to the net equity, the losses of for example Amaranth
Advisors and LTCM and at the Investment bank Barings were nearly equal to or exceeded
those firms’ net equity and pushed all the three into or close to insolvency.
Babak (2008), in his article compares trading derivatives to “juggling running
chainsaws, which also happen to be on fire”. He notes “unless you know what you’re doing,
it will get messy” and that all these losses started out as small loss but “were allowed to
balloon into grotesque proportions”. Moreover, he continues by highlighting that:
“if we allow our convictions to overrule our discipline, we’re headed
towards the same fate. If anything, such gigantic losses should dampen
conspiracy theories of market manipulation. After all, if someone can’t
bully a market with a few billion, then the market is indeed bigger than
anyone and everyone”.
Adams and Runkle (2000) take a slightly different line, arguing that it is the complexity of
derivatives, not their inherent nature that should be seen as a contributory factor to the losses
and failures. Muehring (1995), alternatively, suggests that it is neither the inherent quality of
derivatives nor their complexity that causes major losses and that these are not a necessary
element of mismanagement. He explains that most times this can result from a “can't-lose
mentality” which fails to take note of the downside of the investment.
Das (2006) sees the “world of derivatives trading as a world of beautiful lies,” where the
trading floor is breaken down into salespeople, “who lie to clients, traders who lie to sales and
to risk managers, risk managers who lie to people who run the place (or as it is sarcastically
noted in this article – only think that they run the place); the people who run the place lie to
shareholders and regulators, the quants (sarcastically described as fabulous rocket scientists)
develop a model for lying and lastly the clients, they lie mainly to themselves.”
As Stulz (2005) suggests, that derivative contracts have only made the headlines when
they led to large financial losses. As noted, derivatives have been linked to notable events
ranging from financial to non-financial firms, countries, and counties. Nevertheless, properly
handled derivatives have been very precious to current economies, and will definitely remain
Name Loss
Institution Market % of
Howard “Howie” Hubler 9.0 Morgan Stanley credit default swaps on
Real Estate 11.79%
Jérôme Kerviel 7.2 Société Générale European Index Futures
Brian Hunter 6.5 Amaranth Advisors Gas Futures
John Meriwether 4.6 Long-Term Capital
Interest Rate and Equity
Derivatives 6.02%
Yasou Hamanaka 3.5 Sumitomo
Copper Futures
No Specific Trader 2.9 Kashima Oil Foreign Exchange
Derivatives Trading
(Forex Forwards) 3.80%
William Hunt Nelson Hunt 2.52 Hunt Brothers Silver - Commodity 3.30% 1980
No Specific Trader 2.5 Aracruz foreign exchange options
– on the Brazilian real 3.27%
Wolfgang Flotti & Helmut
2.5 Bawag Currency and interest
swaps 3.27%
Kweku Adoboli 2.3 UBS European equities - S&P
500, DAX, and
EuroStoxx Futures 3.01%
No Specific Trader 2.14 Showa Shell Sekiyu FX Forwards 2.80%
Bruno Iksil known as the
“London Whale” and
2.0 JPMorgan Chase Credit Derivative
Frances Yung 1.82 CITIC Pacific Foreign Exchange
Trading 2.38% 2014
Maksim Grishanin, VP
Finance 1.76 Transneft Derivatives 2.30% 2008
Boaz Weinstein 1.74 Deutsche Bank Derivatives 2.28% 2000
Robert Citron 1.7 Orange County Interest rate derivatives
Wolfgang Flöttl, Helmut
Elsner 1.56 BAWAG Foreign Exchange
Trading 2.04% 1995
George Soros 1.46 Soros Fund SP 500 Futures 1.91% 1987
Nick Leeson 1.4 Barings Bank Nikkei Futures
Heinz Schimmelbusch 1.3 Metalgesellscaft Oil Futures
Toshihide Iguchi 1.1 Daiwa Bank – Resona
U.S. Treasury Bonds
Boris Picano-Nacci 1.06 Groupe Caisse
d'Epargne Equity Derivatives 1.39% 2008
Adriano Ferreira, Álvaro
Ballejo 1.05 Sadia FX and Credit Options 1.37% 2008
Peter Young 0.85 Morgan Grenfell Shares 1.11% 1997
David Askin 0.84 Askin Capital
Securities 1.10% 1994
Friedhelm Breuers 0.82 WestLB Common and Preferred
Shares 1.07% 2007
David Lee 0.8 Bank of Montreal Natural Gas Options
Dany Dattel 0.76 Herstatt Bank Foreign Exchange
Trading 1.00% 1974
David Lee, Kevin Cassidy 0.64 Bank of Montreal Natural gas derivatives 0.84% 2007
Chen Jiulin 0.60 China Aviation Oil
(Singapore) Oil Futures and Options 0.79% 2004
Ramy Goldstein 0.55 Union Bank of
Switzerland Equity Derivatives 0.72% 1998
Chen Jiulin 0.55 China Aviation Oil Jet Fuel Futures 0.72% 2005
Howard A. Rubin 0.51 Merrill Lynch Mortgages (IOs and
POs) Trading 0.67% 1987
A. James Manchin 0.51 State of West Virginia Fixed Income and
Interest Rate Derivatives 0.67% 1987
Joseph Jett 0.49 Kidder Peabody Government Bonds 0.64% 1994
Michael Berger 0.48 Manhattan Investment
Short IT stocks during
the internet bubble 0.63% 2000
Thomas Joyce 0.44 Knight Capital Group Equities 0.58% 2012
No Specific Trader 0.41 Hypo Alpe-Adria-
Bank International
Foreign Exchange
Trading 0.54% 2004
Richard "Chip" Bierbaum 0.35 Calyon Credit Derivatives 0.46% 2007
Marc Colombo 0.328 Lloyds Bank Foreign Exchange
Trading 0.43% 2004
No Specific Trader 0.31 Dexia Bank Corporate Bonds 0.41% 1974
Juan Pablo Davila 0.30 Codelco Copper, silver, gold
futures 0.39% 2001
Raymond Mains 0.22 Procter & Gamble Interest Rate Derivatives 0.29% 1994
Paul Erdman 0.214 United California
Bank of Basel Cocoa futures 0.28% 1970
Liu Qibing 0.21 State Reserves Bureau
Copper Scandal Copper Futures 0.27% 2005
Kyriacos Papouis 0.19 NatWest Interest Rate Options 0.25% 1997
Peter Shaddick 0.164 Franklin National
Foreign Exchange
Trading 0.21% 1974
David Bullen
Luke Duffy
Vince Ficarra
Gianni Gray
0.187 National Australia
Exchange Options
Armin S. 0.176 BNP Paribas Arbitrage Structured Products 0.23% 2016
No Specific Trader 0.15 Cuyahoga
County, Ohio Leveraged Fixed Income 0.20% 1994
Fredrik Crafoord, Mikael
König, Patrik Enblad 0.143 HQ Bank Equity Derivatives 0.19% 2010
Evan Dooley 0.13 MF Global Wheat Futures 0.17% 2008
Matt Piper 0.12 Morgan Stanley Credit-index options 0.16% 2008
Eduard Nodilo 0.12 Riječka banka (Rijeka
Foreign Exchange
Trading 0.16% 2002
Matthew Taylor 0.118 Goldman Sachs S&P 500 e-mini Futures 0.15% 2007
Joseph Jett 0.074 Kidder, Peabody & Co US Treasury bonds.0.10% 1994
Table 1.1 Summary of Trading Losses (Compiled by Author)
In order to determine whether it is misuse of this financial instrument, and not the
derivatives instrument itself, that causes firm failure and large losses, the pertinent
derivatives’ cases of misuse need to be reviewed further. These cases will help to identify
some of the root causes of these incidents. Moreover, one has to look deeper into aspects such
as the environment surrounding their use and the characteristics of the people using them.
One must not look at these cases in isolation. There are also cases of derivative use that have
not resulted in loss or failure and so have escaped publication or media. The author has also
review research studies, interviews and surveys about derivative misuse as a way to help
mediate between them and the condemning and condoning derivatives usage reports. He
compares the findings to specific studies by Bezzina et. al. (2012, 2013), Grima (2017)
and Grima (2012), that used self-administered surveys, interviews and the case of the
financial crisis respectively to discuss the same doubts and myths.
1.2 The Perceived Problem
Derivatives markets are usually seen as illiquid, segmented, politically unstable and
with little regulation. Despite this, the trade of derivatives products on markets and outside
markets (over the counter OTCs) has become more active (as will be discussed in the
following chapters), mainly due to their advantages for market participants. In this book the
author explains and discusses some of the main difficulties to use derivatives properly in the
economies and to provide viable solutions.
Herein the author examines and discusses whether these experienced large losses and
failures when using derivatives is a consequence of the derivative instrument itself.
Furthermore, it will be determined whether and what other factors may have caused or added
to the troubles. Case studies, books, publications, journals, online material including online
interviews and their transcripts and literature need to be looked into, together with online
forums discussions, interviews, and surveys. This will shed light on the misconceptions and
myths about derivatives with an aim to demonstrate whether the incorrect use of the
derivatives instruments and not the instrument itself, can cause a firm or a government entity
to collapse. In sum, the author will herein discuss whether derivatives, if properly handled by
people who manage them, are useful instruments for companies and governments and will
determine the governing conditions, which influence their safe use.
Although much has been written about financial derivatives theories and valuations,
relatively little has been researched on the economic reasons, costs, and the impact of their
use. This is important, given that as Morse (1997) explains that the use and popularity of
derivatives as a tool in corporate investment portfolios has increased. Davis (2009),
emphasises the importance of understanding and being aware of the risks that the world is
facing in terms of size and costs, so as to be prepared for and informed on, how to mitigate a
phenomenon he describes as the ‘Derivatives Chernobyl’.
“Unlike Warren Buffet, Sir Julian Hodge, the Welsh banker, issued his
apocalyptic warning three years before the first rash of derivatives disasters
involving Metallgesellschaft, Orange County, Sears Roebuck, Proctor and
Gamble, happened in 1994. More was to come in 1995 in the form of the Daiwa
and Barings scandals. None of those on their own, however, threatened to bring
the world financial system to its knees, until the crisis that came closest to doing
so was LTCM in September 1998. Nearly 10 years later, in March 2008, the FED
took emergency action to avoid what was called derivatives Chernobyl’. That
action seemed to have worked ... for a while, but the Credit Crunch has raised
worries, could a mega-catastrophe lie around the corner ...?” (Financial Spread
Betting Ltd, 2011)
The objective is to contribute to the growing body of discussion and literature that
expounds the benefits derived from using derivatives and that helps in understanding and
determining the governing conditions that influence their safe and efficient use. Also to
understand and highlight the costs of using derivatives and analysing the validity of the myths
that surround them. Moreover, to strengthen the argument put forward by Davidson’s (2000
p.1) in her introduction to her book ‘Auditing Derivative Strategies’ that reads:
“Derivatives don’t kill companies! Traders and portfolio
managers lose large amounts of money because they don’t
understand how derivative structures work, and companies do not
have the necessary internal controls in place in this highly risky
area to ensure assets are protected”.
She sarcastically continues to blame the media for trying to make everyone believe
that derivatives, rather than people cause all the problems, by slipping into our investment
portfolios to create losses without one knowing. She notes that derivatives like anything else
can be used as a weapon but also suggests that not investing in derivatives is “gambling on
uncertainty” (Davidson, 2000 p.1).
To gain a better understanding of what is happening in the world, and the costs of
derivative misuse, as already noted, the author collates data from a selection of highly
publicised and documented cases of financial firms and non-financial firms (noted below).
Findings are corroborated to studies by Bezzina et. al. (2012, 2013), Grima (2017) and
Grima (2012), to determine their validity and the gaps.
As noted above, cases of losses or failures where derivative instruments were
involved were studied, in order to determine the role derivative instruments played in the
debacles. This allowed the author to understand whether derivative instruments could have in
any way been the culprit or contributed to the losses/failures. However, since only cases with
negative outcomes are usually publicised and highly advertised, this research also looked at
any studies, secondary data from interviews and surveys to try and capture investment
strategies that have been successful. These findings were needed to determine the governing
factors, which influence the efficient use of this instrument. As noted above he does this by
comparing the findings to specific studies that used self administered surveys, interviews and
other the case of the financial crisis to discuss the same doubts and myths. These specific
studies noted above are those by Bezzina et. al. (2012), who investigated the “factors that
safeguard or hinder the proper use of derivatives, with evidence from active users and
controllers of derivatives”. They use Factor analysis to provide support for the five
hypothesised dimensions of proper derivative usage. A later chapter by Bezzina et. al. (2013),
account for the differential success of firms in achieving their objectives for using
derivatives, Grima et. al. (2017), who highlighted in a chapter the results of interviews on the
misuse of derivatives conducted with experts directly or indirectly involved with derivatives
from different European Firms and Grima (2012), who discusses the part played by
derivatives in the last financial crises.
1.3 Losses Involving Derivatives
Several documents have been released over the years in order to provide
recommendations with regard to managing risk and auditing derivatives. As already
discussed, in the last four decades there have been some spectacular losses in the derivatives
markets. These losses did not follow the guidelines for managing and auditing risk. It seems
that due to the inability of management to provide control mechanisms that overarch the
financial, operational, and managerial aspects of companies, the activities of the so-called
‘rogue traders’ are not identified at their onset. With weak foundations for effective controls
and flimsy checks and balances, firms may be expected to fail at many operational and
management levels and in more than one location (Chew, L., n.d.).
In the next chapters, summaries and snapshots of the losses made by financial
institutions and non-financial organisations misusing derivatives are drawn-up to give an
understanding of the authors choice of cases to study further. These are in no way exhaustive
and do not include all cases. One can note here and from table 1.1 above, that in many of the
cases were huge losses arose, it resulted from/or was blamed on the activities of a single
employee and derivatives. Moreover, these cases are not to be viewed as a reflection of the
derivatives trading field as a whole or even as a representative indication of the instrument
itself. The derivatives market is a vast multi-trillion dollar market that by most measures has
been outstandingly successful and has served the needs of its users well. The events
described, although consisting of relatively large amounts, actually represent a tiny
proportion of the total trades (both in number and value). Therefore, it is worth considering
carefully the lessons we can learn to take full advantage. Some notable losses may never be
reported to the public, due to the secretive nature of many banks, non-financial firms,
countries, hedge funds, their management and directors. Therefore, it is very difficult to
determine the full population of losses or bankruptcies where derivatives were involved.
Moreover, more weight has been given to some cases than to others since they give valuable
insight into the problems faced. These cases paint a picture of what can happen if derivatives
are misused.
According to Hamilton and Micklethwait (2006), it has been convenient to pass off
corporate failures as accounting scandals and frauds. In this way, politicians, analysts,
reporters and others involved can dust off the problems by adding to or making some rushed
changes to the legislation, ask for better controls, condemn greed, and go on. This has only
made great news and has only been the “source of juicy headlines and pictures of high-flying
executives in handcuffs.” Although the factors in some cases were similar, this is more
complex and they are not the same in all the cases.
After consulting literature, cases and his experience, the author was able to choose the
most appropriate cases for this review. These cases are listed below in Exhibit 1.2. The author
will probe deeper only into some of the highly publicised and documented cases. That is,
what is believed are representative examples from different industries and countries. This,
however, as already suggested, does not mean that other events/cases of losses and
bankruptcies attributed to financial derivative use, will not be considered (by trying as much
as possible not to generalise because the case studies will only show the detail of a few
firms). Most of the cases are well known because they have attracted widespread media
coverage and legal action.
Exhibit 1.2 Case Studies
Banks Non-financial firms
Barings Bank Enron Corporation
Allied Irish Bank Metallgesellschaft AG
Société Générale
Moreover, after reading through literature and a number of cases (summarised in the
Appendix), the author was able to determine certain propositions/issues/themes (as
suggested by Stake, 1995, Yin, 2003 and Braun and Clarke, 2006), which enabled him to
build the conceptual framework/structure (Exhibit 1.3 below) that guided him through the
review. The author highlighted/coded the factors influencing the safe/proper use of
derivatives as propositions/issues to guide him in determining whether the cases were
affected by them by looking out specifically for them within. However, the author also
labelled/coded one preposition/issue as ‘other’ so as to ensure that he is keeping an ‘open
mind’ and none of the observations is missing ( i.e. not to be strictly stuck to and driven by
a structure, which closes up the chances of determining observations not noted from
theory or experience). The author here is therefore, using both deductive and inductive
approaches in part of the qualitative study.
Exhibit 1.3 Propositions/Issues
Propositions/Issues - Factors Description
aLack of segregation of duties between
front, Mid and back offices.
In most of the cases, it has been seen, that segregation
both physical and logical, was not in place. There were
also cases where segregation existed but was not
working appropriately, since for different reasons the
trader has been able to carry out transactions from
beginning to end or influence others.
bLack of appropriate internal controls and
Inappropriate accounting standards and
It seems that internal controls were not working
appropriately. In many cases, this was due to the young
age and inexperience of controllers or the size of the
control team or the structure, which did not allow
appropriate communication of facts. However, one can
notice the numerous warning signs that went unnoticed.
Warning signs, that should have helped in identifying
problems. Some were so clear, and yet, were not
Also, loose ends in accounting standards and regulations
are seen to have influenced derivative use.
Propositions/Issues - Factors Description
cLack of appropriate supervision It is seen in various cases that although
supervision existed, they were many times
complacent and for various reasons did not
question the work carried out by traders as
long as they seemed to be making money.
dLax regulators and policies Policies and regulations did not develop in line
with the growth and innovations in derivatives.
Moreover, derivatives were largely unregulated
or market competed with each other, rather
than helped each other to regulate
eLack of Knowledge of Managers
(users and controllers)
Knowledge of Managers on derivatives was
limited; this made control difficult to carry out.
Staff was young and new recruits, especially
the controllers. This proposition/issue is further
emphasised in (i) below.
fLack of Communication There was a lack of communication between
Regulators, Auditors, Managers and the Board
of Directors/Audit Committees. Board and
Audit Committees only met up a few times a
year and for a few hours, making it difficult to
identify the issues. Regulators’ communication
with other regulators was poor and information
received on derivatives from users was limited.
Auditors and Managers did not communicate
much and believed in the ‘us and them’
gComplexity and perception of the
usefulness of derivatives
Although derivatives can take a ‘plain vanilla’
form, they can also be very complicated
especially when drawn-up (custom made)
‘over-the-counter.’ Also, there are many myths
that surround the instrument, that has
influenced their usage.
“too complicated to explain, but too
complicated to ignore” Perceived wrongly as “a
monstrous global electronic Ponzi scheme”
(Henry Gonzalez, former House Banking
Committee Chairman cited in Jorion, 2009).
Propositions/Issues - Factors Description
hGreed, hubris and the desire for
“This is a person who has gotten us millions of
dollars. I don’t know how in the hell he does it,
but it makes us all look good” (Orange County
Supervisor Thomas Riley, 1994, talking about
Robert Citron, cited by Jorion, 1995).
As noted, nobody dared touch the ‘goose that
laid the golden egg’ or supposedly did so. Most
of the traders or so-called ‘rogue traders’ were
arrogant and had strong characters. They
craved power and felt like Gods. Nobody was
able to touch them.
iExperience and Education As already noted, in the text above, “Wall
Street wise man Felix Rohatyn, Speaking of
derivatives, has warned 26 year-olds with
computers are creating financial hydrogen
bombs.” Jorion (1995). However, This has also
been noted with controllers who were young
and inexperienced.
JThe Black-Scholes Formula “The whether the LTCM disaster
was merely a unique and isolated event, a bad
drawing from nature’s urn; or whether such
disasters are the inevitable consequence of
Black-Scholes formulae itself and the illusion it
may give that all markets participants can
hedge away all their risk at the same time”
(Merton H.Miller, Nobel Laureate cited in
Lowenstein, 2000).
1.4 Review Questions
The author seeks to answer the following two questions:
1. What are the governing factors that influence the safe use of derivatives? : Every
instrument and product has a risk and reward attributed to it. To answer this question, the
author needs to highlight these (risk and reward) and understand the role played by
derivatives in the debacles. He also needs to determine the significance and consequences
of using derivatives, thus highlighting those fundamental issues, which emerge as
predictors of the difficulty often encountered by firms when using derivatives,
occasionally leading to their misuse. He also needs to understand the way these
instruments have been and are being misused and to determine whether there are any
common characteristics. This will then enable the author to understand whether there is a
possibility of managing the risks and ensuring the safe use of these instruments.
2. Is the problem the derivative instrument itself? Should derivative use be considered
madness? Are they so bad and dangerous?: The author here asks the question whether the
derivative instrument itself may be the reason for misuse and whether using it can only
lead to trouble. He asks whether the instrument itself may be attracting criminals and fraud
- Is it an easy target/tool for misuse? If so, do the potential benefits from using derivatives
outweigh the potential threats? Here, the interest of the author is to determine whether
derivative instruments pose any risks and if so, are these risks greater than in other
instruments. Moreover, he is interested in understanding whether these risks are a result of
how users and controllers perceive derivatives and whether this has any effect on the safe
use of derivatives.
1.5 Perception
The perception is that there are a manifold of reasons concerning ‘users’ and
‘controllers’, rather than the derivative instruments themselves, that lead to unprofitable
decisions. To blame derivatives, as Bartram (2009) suggests, is like blaming a car for causing
a crash, as opposed to the drunken driver behind the wheel. Very often, the blame for
spectacular collapses and billion-dollar losses of firms is erroneously attributed to the
derivative instrument itself. This is done without looking at important implications such as
the reason for absolving the culprits from any responsibility. Thus, the true value and
qualities of the derivative instrument is obscured.
David Hale, Economist, Zurich Kemper Investments “At fault may be a global
business culture that lavishly rewards traders who take risks but not the people who are
supposed to supervise them”, (Egan, 1996)
As the above quote by Hale cited in Egan (1996) suggests, firms are eager to reach
into their pockets to look at innovative ways of making profits and paying for good
salespersons. However, they are less ready to spend money and time to put in efficient and
appropriate controls. Also, in “an environment where firms and derivative traders are
motivated with multimillion incentive packages, a low budget oversight system by
inexperienced controllers is clearly not the appropriate tool to control and manage risk”
(Bezzina 2012).
Brent McClintock (1996) notes in an article “International Financial Instability and
the Financial Derivatives”, that:
the rapid growth of the derivatives market has been accompanied by a lag in
instituting regulatory controls that would limit the destabilising impact of
these new financial innovations. Since many derivatives involve cross-border
trading, the derivatives market has led to increased international financial
fragility and the attendant need for greater supranational governance of
Moreover, Pierre Paulden, Jacqueline Simmons and Hamish Risk (2007) noted in an
article “Calyon Trader Fired for Losses, Says He's No Rogue”, in Bloomberg, that Nick
Leeson said, in an interview in Dublin, that:
“continued losses show that banks don't want to spend the money needed
to prevent rogue trades and over the last 10 years there have been several
large financial scandals that have lost billions of dollars and yet people
don't really have the systems and controls in place, one has to ask why?”
This increases the gap between the greed to take risks and understanding the risks and
managing them. It is noted that the gap between risk-taking and risk management (or more
simply put, greed) is a factor that increases misuse and not the instrument itself. The
conclusion reached by Stephanie Baker-Said and Elena Logutenkova (2008) is pertinent here;
they note that it is really people within the organisation, who encourage misuse, not the
market, not the competition, not inadequacies in technology or the systems in place (Bezzina
et, al.,2013).
Exhibit 1.4 above depicts the conceptual framework of the review. It shows that to
address the problem and to answer the questions, six sub-questions were independently
considered in each of the data collection sources.
The literature review provides the background for the study by looking at the
growth in derivatives, regulatory development, control structures, characteristics of
derivatives, and their markets by utilising the sociological theory of derivatives and their
markets. It also sets the foundations for identifying the purpose of using derivatives, outlining
the benefits and determining the gap between the original reasons and the actual reasons
(acquired reasons). Moreover, it looks into the development and changes in regulations,
controls, and politics especially following incidents of derivative use failure. The different
control structures and frameworks and the effect of politics (both external and internal) on
derivatives use are discussed. Moreover, the gaps existing between the spirit for having
certain regulation and controls and the actual outcome and impact are noted.
The secondary data from interviews, case studies, online forums, researchers’
experiences and surveys helped provide insight into the knowledge and expertise on
derivative use by looking at the different determinants of derivative misuse and the gaps that
still need to be filled in to ensure safe use. The author is also conscious of the fact that the gap
may not relate to one specific factor or only one factor such as education or qualifications,
but may relate to other additional factors within the firm such as employment of personnel
with the incorrect criteria or personal characteristics requirements. The reasons for this and
whether it is intentional or not, is reviewed. Moreover, the gap between what users are
supposed to know about, or should be aware of when using derivatives, what they actually
know or are aware of and the resulting impact, is also being analysed. In doing this, the level
of difficulty (complexity) faced by users when using derivatives, the impact that particular
characteristics (e.g. character, gender, age and environment of derivatives users and
controllers) might have on derivative misuse is explored and analysed.
1.7 Research, Papers and Studies on Derivative Instruments
In the last two decades, a number of studies and papers have examined derivatives use
and misuse from various angles using similar or different methodologies and addressing both
financial and non-financial firms. There are papers, which relate the chronology of how
derivatives and derivative markets started and continued to grow. There are others that have
tackled the lessons learnt from large financial losses and bankruptcies blamed on derivative
use. Some have relied on surveys or interviews carried out, focussing on the same aspects or
different aspects in different countries or continents. However, all have in one way or another
helped increase the growing knowledge and literature on the safe use of derivatives. Some of
these studies are noted and summarised in the following Chapter.
1.6 Conceptual Framework/Structure of the Review
Exhibit 1.4 Conceptual Framework/Structure of the Review
One of the main study groups on derivative instruments is the Global Derivatives
Study Group sponsored by the Group of Thirty (G30). This group works separately from the
regulatory authorities, on developing appropriate supervisory practice and sound risk
management practices and principles. It uses diversified methodologies such as case studies
and holding discussion groups and online forums. The case study analyses they carry out are
referred to later on in the following chapters.
There are studies such as that carried out by Mian (1996) that analyse the use of
derivatives in non-financial firms using market and financial statement data. In this empirical
study, а sample of 3.022 firms are used to find evidence of the factors that influence the
corporate hedging policy. Mian classifies the firms into hedgers (771) and non-hedgers
(2,251) using the annual financial statements of 1992 25.5% utilisation rate). Nаncе,
Smith, & Smithsоn (1993), on the other hand, delved deeper into 169 firms’ hedging
activities, which were chosen from Fortune 500 and S&P 400. They determined that in that
fiscal year most corporations (104) had used hedging instruments. Their results show that
hedging decision did not relate to financial distress and agency costs, but to the investment
tax credit. Furthermore, Jacky, Minton and Strand (1997), found а 41.4% usage rate of
derivatives when investigating Fortune 500 non-financial firms (372), with a potential
exposure to foreign currency risk (basing this on 1991 financial statements).
Other studies have used large-scale surveys, such as the three conducted by specialists
within Wharton Schооl in 1994. Bednorz, Hoyt, Marston, and Smithsоn published the first of
these in 1995. The second survey sponsored by CIBC Wood Gundy was conducted in 1995; it
is more detailed than the 1994 survey, with a much wider array of questions relating to
valuation and risk management and with the questions on the use of derivatives being more
specific. In October 1995, these same questionnaires were sent (through mail) to the same
sample used in the 1994 survey but adding the remaining Fortune 500 firms previously not
included. In total there were 350 responses from the manufacturing sector (176), the primary
products sector (77) (i.e. agriculture, mining, energy and utilities), and the service sector (97).
The last study carried out in partnership with CIBC World Markets in 1998, extended on the
previous surveys by asking new questions relating to certain aspects of derivative use and risk
management practices.
Based on these surveys and following similar methodologies, other studies have been
carried out on the handling of derivatives in the U.S. market and globally. These included
surveys еmplоyеd in studies on derivatives’ used in Jаpаn (Yаnаgidа & Inui, 1995), Cаnаdа
(Dоwniе, McMillаn, & Nоsаl, 1996), Sweden (Аlkеbаck & Hаgеlin, 1999), аnd Аustrаliа
(Nguyеn & Fаff, 2002). One of the main reasons for using derivatives was found to be that of
minimising instability in the cash flow and also covering for risk by decreasing the chances
of loss probability. Similar results were obtained by Barmen еt аl (1997), Jоsеph аnd Hеwins
(1997), аnd Bednorz аnd Gеbhаrdt (1998) in New Zеаlаnd, England and Germany. Also,
similar studies were carried out on emerging countries, especially Latin Аmеricа. Rivаs-
Chаvеz (2003) on the other hand shows the notable use of derivatives by financial firms in
Brazil, Mexica and Chile and find that Latin Аmеricаn bаnks do not offer derivatives so as to
lower interest rate and credit risk. Moreover, they find that derivatives usage is unrelated to
the efficiency of these banks.
Another, similar study, was carried out by Barmen and Bradbury (1996), who sampled
116 firms, which were listed on the New Zealand Stock Exchange. They found that the use of
derivatives risks rises with factors such as leverage, company size, taxes, and the proportion
of shares held by managers and decreases with the increase in liquidity and interest coverage.
In a later study on New Zealand firms, Provost, Rоsе, & Millеr (2000) found the same pattern
as the other studies.
Apart from the studies by Bezzina et. al. (2012, 2013), Grima (2017) and Grima
(2012), a study which the author finds significant for this book was drawn-up by Johannes
Conradie Bruce for his doctorate in the subject of sociology at the University of South Africa
in 2007. This dissertation was entitled ‘The Role of Structural Factors Underlying Incidences
of Extreme Opportunism in Financial Markets’. He uses a sociological approach to analyse
incidences of extreme opportunism in financial markets, through an analysis of case studies
involving “rogue” trader events. He keeps an ‘open mind’ and blends theory and reality to
understand the phenomenon known as ‘rogue trading’ and determine what encourages it or
alternatively if they are in fact truly scapegoats. Not all cases involve the use/misuse of
1.8 Significance/Contribution of the Review
Although, there have been new studies on derivatives and their activity, with the
exception of Bezzina et. al. (2012, 2013), Grima (2017) and Grima (2012), there does
not appear to be many studies that analyse the reasons for derivative misuse in the same
manner conducted in this review. In one way or another, all the studies that have been carried
out have contributed to the vast literature on the subject. Moreover, many authors and
journalists have followed and focused their attention on losses blamed on derivatives, making
transcriptions of interviews carried out with the so-called ‘rogue traders’ to writing
biographies of the events. Others have focused on understanding derivatives and their
contribution or on controls needed to ensure their safe use writing textbooks for colleges
and universities, preparing course texts, contributing to legislation and standards for best use
and drafting regulatory guidelines. Moreover, there are forums and online sources, which
have helped in the development of derivative use by giving professionals and academics in
the area tools to enable discussions and share articles.
This review, however, discusses the uses and misuses of derivatives and looks for the
governing factors, which influence the safe use of derivatives and uses various tools to
determine whether derivatives are really at fault. It is based upon a neutral, but relatively
optimistic outlook, on the potential of derivatives and contends that losses and bankruptcies
do not occur because of the derivatives instrument themselves. There will be a contribution to
the increasing body of literature on firm failures and losses attributed to derivatives and the
controls therein. Moreover, this book discusses the myth surrounding derivatives and firm
failures by showing that derivatives are an essential corporate tool when properly used to
hedge against risk. Since derivatives myths still condition the minds of management and
corporate directors, a further review needs to be conducted to develop ways of educating
them on derivatives. This book is focused on identifying clear controls to ensure derivatives
can be used in a safe manner and at the same time be beneficial to the relevant parties. The
author also takes the stance of a researcher practitioner’s view. This helps contribute to the
practical part of this study bringing academia and reality closer to each other (James and
Vinnicombe, 2002).
1.9 Summary
The large growth of derivatives use and markets together with the continuous news on
derivatives-related losses over the last decades has created considerable public debate about
the benefits, risks, control and proper regulation of these financial instruments. Legislators,
regulators, controllers, users have shown concern on the risks that this global financial
instrument might bring to individual firms, specific markets, and the overall economy.
As noted throughout this chapter, fears remain that some investors do not understand
the instrument and they may well be exposed to risks that they do not understand. For now,
the risk seems to be well diversified, with many more investors involved than at any previous
time. Holders of risk should act like cоncеrnеd parents watching their toddler at the
swimming pооl, never letting their еyеs stray from their charge. Notwithstanding the
developments in the last few decades, the exotic nature of derivatives that often baffles the
public seems to remain. Maybe because they have learnt about them from the much publicity
given to cases involving large losses.
Thus, the derivatives appear to the public as a spectre over financial stability. “The
complexity of derivatives and the need for transparency in their reporting have led to a debate
in the accounting profession that culminated in the reporting requirements as set forth by the
Financial Accounting Standards Board (FASB) in SFAS No. 133,” Accounting for Derivative
Instruments and Hedging Activities (1998).
Finally, the objective of this review is to examine and analyse whether the large losses
and failures experienced by firms when using derivatives is a consequence of the derivative
instrument itself and to determine whether other factors may have caused or added to this.
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