There's nothing wrong with the Nikkei 225 futures and options contracts, even though Barings PLC collapsed after losing something on the order of a staggering $1 billion investing in them. In fact, there's nothing wrong with any derivatives in the right hands, where their financial energy can be harnessed for prudent speculation, risk taking and hedging. The problem with derivatives is the potential destructiveness they can unleash in the wrong hands. In such hands they can - and have - become an instrument of financial terrorism.
In fact, besides greed, hubris or incompetence, financial terrorism could motivate the misuse of derivatives. Studies of derivative problems have neglected this motivation. The terrorist motive needs serious and quick examination by all users of derivatives and by regulators. With derivatives, a terrorist, whether a malcontent employee or a politically motivated plant, could fire financial neutron bombs and destroy entire institutions, no matter how financially solid they are, like Barings or Orange County, leaving only employees, shareholders, creditors and, usually, taxpayers as survivors to clean up the financial radioactive fallout.
A market meltdown, rightfully dismissed a few years ago, has more possibility now, as huge entities like Barings fail. At the same time, Barings and Orange County show how strong the market is, withstanding such blasts. So there is no clear conclusion about the market's vulnerability to derivatives.
Many in the financial industry speak of such spectacular derivatives losses as Askin Capital Management Inc., Procter & Gamble Co., Kidder Peabody & Co., Metallgesellschaft AG, Orange County and Barings as isolated incidents. But such "isolated incidents" within a year's time must cause concern, just as airplane crashes involving similar aircraft would cause concern and lead to a search for preventive measures.
The Bank of England did the right thing by letting Barings fail. Fear of such failure should instill market discipline in other users of derivatives. Yet, this loss still may not persuade others of the need for better controls. Widely publicized derivatives losses in 1994 did not prevent other damaging losses.
The lesson in the Barings collapse is not to avoid or ban derivatives. The correct lesson is to proceed with caution. Many overseers, from the Financial Accounting Standards Board to custodians at trust departments, have been slow to provide better disclosure rules and systems to enhance monitoring.
By their nature, derivatives are highly sensitive; small shifts in a market or a security can cause sudden huge rises or falls in derivatives, especially easily leveraged positions. Thus, users must have equally highly sensitive warning systems and controls.
Unfortunately, the Group of 30 recommendations for tighter internal controls, issued almost two years ago, appear still widely unheeded.
Prudence doesn't mean avoiding speculative bets. It means having a solid grasp of the risk of a failure and making only bets within the ability to manage or bear any loss. The maverick bet at Barings was fully outside its ability to manage.
Top management must control the pushing of the derivatives button and must continuously monitor the risk of those outstanding derivatives once launched through the equivalent of a hotline phone. Such a system will reduce the chance of terrorists, knaves or fools misusing them with disastrous results.