Risk of limitless derivatives
Skip to main content
pilogo-NEW
Subscribe
  • Subscribe
  • My Account
  • login
  • NEWS
    • Asset owners and the coronavirus
    • Alternatives
    • Consultants
    • Coronavirus
    • Defined Contribution
    • ESG
    • Frontlines
    • Hedge Funds
    • Investing / Portfolio Strategies
    • Money Management
    • Pension Funds
    • People Moves
    • Private Equity
    • Real Estate
    • Searches & Hires News
    • SECURE Act
    • Special Reports
    • WorldPensionSummit
    • Ron Schmitz
      Pandemic drives faster transition for Virginia to private markets
      Mubadala Investment Co. logo
      Mubadala draws on portfolio in coronavirus fight
      T.J. Carlson
      Texas Muni reduces downside risk during pandemic, finding opportunities now
      Scott Davis
      ‘Triage plan’ at Indiana system helped stem losses
    • KKR lifts out 3 to focus on clean energy infrastructure
      Richard Johnson
      Appian Capital Advisory adds global investor relations head
      Alternative investment funds faced liquidity squeezes in COVID-19 crisis and 2019
      CI Financial launches global real estate, infrastructure joint venture
    • Callan brings on 2 executives
      Hub International agrees to buy Plan Sponsor Consultants
      Aon names public markets solution leader
      Deloitte to acquire Sydney-based consulting firm Rice Warner
    • BofA: Most managers bullish on economy, markets
      Alternative investment funds faced liquidity squeezes in COVID-19 crisis and 2019
      Jerome Powell, chairman of the Federal Reserve, listens during a Senate Banking Committee hearing in Washington on Dec. 1, 2020
      Fed saw some time before taper conditions met – minutes
      International Monetary Fund and World Bank spring meetings signage at the IMF headquarters in Washington
      IMF upgrades global growth forecast, warns of diverging recoveries
    • Pentegra launches pooled employer plan
      Teresa Hassara
      Ascensus taps MassMutual alum as new FuturePlan president
      Economic Group Pension Services scoops up third-party administrator
      OregonSaves gathers $100 million in assets
    • Tracker gives investors insight into progress on social commitments
      Shoppers wear protective masks while visiting an Apple Inc. store at George Street in Sydney, Australia, on June 24, 2020.
      Apple backs SEC mandate on climate disclosure
      Emissions rise from the Kentucky Utilities Co. Ghent generating station in Ghent, Ky.
      Investors, businesses call for ambitious emissions goals
      Signage for Temasek Holdings Pte. is displayed during a news conference following the company's annual review in Singapore
      Temasek, BlackRock partner to launch carbon-cutting funds
    • Ken Griffin
      Ken Griffin donates $5 million to give Miami students internet
      New book culls institutional wisdom from podcast series
      Fearless Girl
      SSGA’s Fearless Girl statue now shattering glass ceiling
      Tangen video
      Norges chief dons chef’s hat to boost employees’ spirits
    • Karen Karniol-Tambour
      Bridgewater appoints 2 co-CIOs to oversee new sustainable investing group
      Hedge funds post best first-quarter return since 2000
      Jason Kephart
      Managers see good times ahead in 2021
      Jev Mehmet, CEO of Brevan Howard's Coremont unit
      Brevan Howard runs $50 billion unit like BlackRock’s Aladdin
    • Connecticut earmarks $200 million to 4 alts funds
      Karen Karniol-Tambour
      Bridgewater appoints 2 co-CIOs to oversee new sustainable investing group
      SSGA selects head of continental Europe for global institutional group
      Ontario Municipal promotes from within for new global equities exec
    • SSGA selects head of continental Europe for global institutional group
      BofA: Most managers bullish on economy, markets
      The Absa Group logo displayed in Pretoria
      Absa shuts $6 billion mutual fund, sparking spinoff speculation
      Mirova adds proxy voting and engagement leader
    • Ontario Municipal promotes from within for new global equities exec
      Kansas City Employees adopts global strategy with small-cap swing
      Michael C. Viteri
      Arizona appoints new CIO
      A £10 sterling bank note with a pound coin and a ballpoint pen, with focus on the word 'pension.'
      U.K. defined benefit plans’ surplus surges in March
    • Karen Karniol-Tambour
      Bridgewater appoints 2 co-CIOs to oversee new sustainable investing group
      SSGA selects head of continental Europe for global institutional group
      Ontario Municipal promotes from within for new global equities exec
      Mirova adds proxy voting and engagement leader
    • Bills of euro, dollar and pound currencies, among others
      Ardian closes latest buyout fund at $8.8 billion
      Hand typing on stationary iPhone at an office reception desk
      Private equity’s taste for tech spurs $80 billion deal spree
      Vista Equity promotes 2 to leadership roles on 2 funds
      Azimut takes minority stake in HighPost
    • CalSTRS indutrial property
      Investors hungry for industrial properties
      Tim Wang
      GLP names co-president of logistics, industrial real estate for China
      Frank Forster
      StepStone Real Estate adds managing director for Europe
      Christine Iacoucci
      BentallGreenOak promotes from within to fill Canadian CIO role
    • Andy Schreiner
      New PEPs targeting firms without retirement plans
      Jackie Walorski
      Contribution catch-up for caregivers gaining favor
      Retirement cartoon
      Hopes rising for retirement readiness in 2021
      Neal and Brady
      Retirement security could be only issue both sides accept
    • Corporate pension contributions
      Eddy Awards 2021
      COVID-19: One year in
      Charging Bull, sometimes referred to as the Wall Street Bull or the Bowling Green Bull, a bronze sculpture that stands on Broadway just north of Bowling Green in the Financial District of New York City
      Top-performing managers Q4 2020
    • U.S. still a key market for investors
      Collected coverage of P&I's 2020 WorldPensionSummit
      Pedestrians pass a large advertisement on the Arndale Center shopping mall reading 'Act now to avoid a local lockdown' in Manchester, England
      COVID-19 puts new opportunities and risks on the agenda - WPS panelists
      Screens display stock price information over the trading floor of the NYSE Euronext exchange in Paris
      Private assets will continue to grow in portfolios – WPS panelists
  • Data
    • Research Center
    • Searches & Hires Database
    • Searches & Hires News
    • RFPs
    • Charts / Infographics
    • Sponsored Research
    • Trackers
    • Q2 2020 searches and hires overview report
      Q2 2020 money manager M&A activity summary
      Q2 2020 legal overview report
      Q1 2020 searches and hires overview report
    • Connecticut earmarks $200 million to 4 alts funds
      Orlando pension funds pick Axiom for emerging markets equity
      St. Louis Public Schools assigns $5 million to value-added real estate
      BayerInvest taps BlackRock to run ESG-focused private debt allocation
    • Connecticut earmarks $200 million to 4 alts funds
      Orlando pension funds pick Axiom for emerging markets equity
      St. Louis Public Schools assigns $5 million to value-added real estate
      BayerInvest taps BlackRock to run ESG-focused private debt allocation
    • Passive Investment Management Services
      Active Extended Global Credit Manager Search
      Actuarial Services
      Investment Management Services
    • Managed account adoption stalls in 2020
      U.S. bonds have worst quarterly return since 1981
      Stable value retains edge over money market funds
      Taiwan Semiconductor’s No. 1 in the emerging markets book
    • Institutional Investors: Shared Expectations, Divergent Paths
      Global Investor Study 2016
      Workplace Financial Wellness
    • U.S. Endowment Returns Tracker
      Pension Fund Returns Tracker
      Earnings Tracker
      Corporate Pension Contribution Tracker
  • Insights
    • Opinion
    • White Papers
    • Industry Voices
    • Letters to the Editor
    • Partner Content
    • Publisher's Update
    • CalPERS cartoon
      Urgency underscores CalPERS' search for a CIO
      Multiemployer plans cartoon
      Money — but no fixes — for multiemployer plans
      Vaccination cartoon
      Rallying to meet the ongoing COVID-19 challenge
      Tesla cartoon
      Don’t confuse wealth creation with retirement saving
    • Bipsync Client Stories: RMS in Action at Pensions and Superannuation Funds
      COVID-19 Makes LP Portfolio Management More Important Than Ever
      China: the outlook is bright for longer-term investors
      Finding Differentiation in Securitized Assets
    • Greg Shea and Steven Kindred
      Commentary: The solution for yield-seeking allocators may be hiding in plain sight
      Jim Park
      Commentary: Asian Americans, Pacific Islanders face ‘bamboo ceiling’ in money management
      Jared Gross
      Commentary: Anchors and allocations – breaking the grip of 60/40
      Peter Marber
      Commentary: Is it time for an emerging markets rally?
    • Writer using a typewriter
      OCIO industry needs to adopt GIPS
      Writer or journalist workplace. stock illustration
      Even as it assails China, Trump administration emulates it
      Skeptical of Main Street support for proxy adviser proposal
      Focus on manager diversity pushes asset owners’ to walk the talk
    • P&I Content Solutions
      Research for Institutional Money Management
      P&I Content Solutions
      Top questions for institutional investors
      Sponsored Content By Newton Investment Management
      Growth and Innovation in Emerging Markets
      P&I Content Solutions
      In Challenging Markets, Systematic Global Macro Strategies Could Hold Opportunity
    • Help us help you by supporting quality journalism
      You Must Believe in Spring
      Everything Must Change
      Tomatoes & Investments
  • Multimedia
    • Videos
    • Webinars
    • Polls
    • Slideshows
    • Charts / Infographics
    • watch video
      1:23
      The passive fixed-income glut
      watch video
      1:38
      Is it time for DC plans to embrace private equity?
      watch video
      5:39
      The coronavirus pandemic: One year later
      watch video
      0:45
      Private funds weathered 2020 turmoil
    • New Outlook on Income: A Framework for Evaluating DC Retirement Income Solutions
      Understanding the PEP Evolution
      Divest or engage?
      Innovations in DC: Helping supercharge retirement outcomes
    • POLL: The Biden infrastructure plan
      POLL: Retirement income solutions
      POLL: Working after the pandemic
      POLL: The year ahead for the 1,000 largest U.S. retirement funds
    • view gallery
      9 photos
      Coronavirus and the markets
      view gallery
      22 photos
      The 1,000 largest retirement funds: 2020
      view gallery
      10 photos
      Outlook 2020
      view gallery
      10 photos
      2019 as seen through the eyes of Roger
    • Managed account adoption stalls in 2020
      U.S. bonds have worst quarterly return since 1981
  • Events
    • Conferences
    • Webinars
    • DC Investment Lineup Virtual Series
      ESG Investing Virtual Series
      Private Markets Virtual Series
    • New Outlook on Income: A Framework for Evaluating DC Retirement Income Solutions
      Understanding the PEP Evolution
      Divest or engage?
      Innovations in DC: Helping supercharge retirement outcomes
  • Careers
  • Research Center
MENU
Breadcrumb
  1. Home
  2. Print
October 27, 2008 01:00 AM

Risk of limitless derivatives

Curbs could mitigate market crisis and value destruction

Philip J. Lee
  • Tweet
  • Share
  • Share
  • Email
  • More
    Reprints Print

    The ability to create an infinite supply of stock option puts, credit default swaps and other derivatives — and thus infinite leverage compared to the underlying asset — carries significant blame for the credit market debacle and drain in corporate valuations.

    Buy enough put options, and the stock will have a propensity to dive. The same logic applies to credit default swaps. When a large volume of protection is sought for a company, the CDS spread widens and the debt value declines.

    This situation worsens dramatically because there is no limit to the amount of stock option puts and default swaps that can be created. At multiples of the underlying value of the assets, derivative shorts can exert an inordinate strain on company values, well beyond that achievable through credible shorts or sales by the actual security owners.

    The problem reaches beyond corporate valuations. Financial institutions can create unlimited derivatives of any kind — currencies, commodities, real estate, equities, debt — without the consent or knowledge of the underlying asset holders. While that ability already creates anxiety because of the potential corporate value destruction, the extension of derivatives influence to nearly every asset class should serve as a real wake-up call.

    Another issue with endless derivatives creation is the degree of influence that any active financial company can subsequently wield. Given the unrestrained ability to create, sell and buy in the derivatives market, any party could conceivably make itself structurally important through extensive participation. The collapse of a large derivatives organization could evolve into a nightmare scenario for credit markets, as it has with the fall of Lehman Brothers Holdings Inc.

    With all of these factors in mind (the ability to influence any asset, the ability to create this influence), one might expect that the only participants allowed to engage in such activities would be a select group of prudent, highly capitalized actors who hold the stability of our financial system in the highest regard. Perhaps these parties would serve as trustees for the functioning of the financial markets.

    Reality is closer to the opposite. Nearly anyone can participate, without consideration for the long-term viability of the financial system. Most incentives are short-term, and while asset-level capital requirements exist, thousands of players do not have firm-level leverage constraints.

    Taken together, the allowance of players who could create a countless supply of derivatives, which could then push and pull values far from the underlying asset without regard for the sustainability of the U.S. financial framework while using leverage for the purpose of maximizing short-term gains, does not seem prudent. In the end, because regulators have allowed this activity and the financial system is now at risk, the taxpayer must bail everyone out.

    While a few suggested solutions point in the right direction, the current set of proposals is piecemeal and incomplete. The best recommendation to date has been the CDS clearinghouse, which would effectively remove systemic counterparty risk, create guidelines that limit exposures, add transparency for oversight and provide regulators with the means to enforce rules. But unless all over-the-counter derivatives are cleared in this fashion, significant risks remain. Yet central clearing for all derivatives is suboptimal because customized contracts are important in solving real problems and standardization severely reduces incentives for innovators.

    A more complete remedy would be for credit-rating agencies, financial companies and regulators to agree on the degree of acceptable leverage for each asset class and market participant. Limits on the amount of derivatives outstanding relative to underlying assets are warranted because company-specific leverage constraints and capital requirements alone are not enough to ring-fence potential damage, as seen with American International Group Inc. Still, largely unregulated institutions such as hedge funds should be subject to risk-protection measures such as capital ratios. At the asset level, leverage multipliers could be assigned based on market value, liquidity, volatility, true economic hedging need, importance in price discovery, correlation with other assets and relative significance within the context of the global market.

    The salutary effects from these recommendations are considerable. Leverage restrictions on puts and credit default swaps impose a more realistic boundary on the extraordinary valuation pressures faced by companies. Potential for value destruction in other areas is reduced. Financial institutions become less risky. And financial stability improves because derivatives outstanding would grow in some proportion to both underlying assets and the balance sheet of financial institutions.

    In all this, we must delicately balance the objectives of providing enough market liquidity and latitude for innovation, without jeopardizing the entire system.

    At this juncture, Washington has moved to stem the tide of financial disaster, but has not yet addressed an important cause. Until the leverage problem is rectified, companies, creditors, shareholders and the financial system will be at risk. The government will have no choice but to intervene each time. Worst of all, the nightmare could recur, draining taxpayer resources until corrective action is finally taken. Let's fix this now.


    Philip J. Lee is a New York-based senior global fixed-income strategist at Barclays Capital Inc., the investment banking division of Barclays Bank PLC. The views expressed in his commentary article are his own and not necessarily the views of his employer.

    Recommended for You
    Read the print edition of P&I
    Read the print edition of P&I
    Gender diversity is improving on FTSE 350 boards
    Gender diversity is improving on FTSE 350 boards
    FINRA honors Wharton's Olivia Mitchell with Ketchum Prize
    FINRA honors Wharton's Olivia Mitchell with Ketchum Prize
    Research for Institutional Money Management
    Sponsored Content: Research for Institutional Money Management
    sponsored
    Events
     
     
    Sponsored
    White Papers
    Bipsync Client Stories: RMS in Action at Pensions and Superannuation Funds
    COVID-19 Makes LP Portfolio Management More Important Than Ever
    China: the outlook is bright for longer-term investors
    Finding Differentiation in Securitized Assets
    Green and sustainable bonds in emerging markets
    Portfolio Protection: One Size Fits None
    View More
    Sponsored Content
    Partner Content
    The Industrialization of ESG Investment
    For institutional investors, ETFs can make meeting liquidity needs easier
    Gold: the most effective commodity investment
    2021 Investment Outlook | Investing Beyond the Pandemic: A Reset for Portfolios
    Ten ways retirement plan professionals add value to plan sponsors
    Gold: an efficient hedge
    View More
    E-MAIL NEWSLETTERS

    Sign up and get the best of News delivered straight to your email inbox, free of charge. Choose your news – we will deliver.

    Subscribe Today
    April 5, 2021 Page One

    Get access to the news, research and analysis of events affecting the retirement and institutional money management businesses from a worldwide network of reporters and editors.

    Subscribe
    Connect With Us
    • RSS
    • Twitter
    • Facebook
    • LinkedIn

    Our Mission

    To consistently deliver news, research and analysis to the executives who manage the flow of funds in the institutional investment market.

    pilogo-NEW
    About Us

    Main Office
    685 Third Avenue
    Tenth Floor
    New York, NY 10017-4036

    Chicago Office
    150 N. Michigan Ave.
    Chicago, IL 60601

    Contact Us

    Careers at Crain

    About Pensions & Investments

     

    Advertising
    • Media Kit
    • P&I Content Solutions
    • P&I Careers | Post a Job
    • Reprints & Permissions
    Resources
    • Subscribe
    • Newsletters
    • FAQ
    • P&I Research Center
    • Site map
    • Staff Directory
    Legal
    • Privacy Policy
    • Terms and Conditions
    • Privacy Request
    Pensions & Investments
    Copyright © 1996-2021. Crain Communications, Inc. All Rights Reserved.
    • NEWS
      • Asset owners and the coronavirus
      • Alternatives
      • Consultants
      • Coronavirus
      • Defined Contribution
      • ESG
      • Frontlines
      • Hedge Funds
      • Investing / Portfolio Strategies
      • Money Management
      • Pension Funds
      • People Moves
      • Private Equity
      • Real Estate
      • Searches & Hires News
      • SECURE Act
      • Special Reports
      • WorldPensionSummit
    • Data
      • Research Center
      • Searches & Hires Database
      • Searches & Hires News
      • RFPs
      • Charts / Infographics
      • Sponsored Research
      • Trackers
    • Insights
      • Opinion
      • White Papers
      • Industry Voices
      • Letters to the Editor
      • Partner Content
      • Publisher's Update
    • Multimedia
      • Videos
      • Webinars
      • Polls
      • Slideshows
      • Charts / Infographics
    • Events
      • Conferences
      • Webinars
    • Careers
    • Research Center