In some cases, dealers may choose to leave some portion of their derivatives-related market exposures unhedged. The Commodity Futures Trading Commission's 1993 survey of 14 OTC derivatives dealers found all held less than fully hedged positions, although all but one denied speculative intentions. Institutional Investor in 1990 reported outstanding derivatives positions allow some dealers to take positions in their own accounts without having to find the other side of the trade: "Dealers say that as much as half of the profits from a derivatives business comes from this sort of trading rather than the initial bid-ask spread."
Typically, however, dealers will attempt to offset counterparty trades in order to control market exposures. With interest rates and currency swaps, for example, a dealer basically will serve as an intermediary between two counterparties, so that payments to (or from) one are mirrored by payments from (or to) the other. By breaking down all their transactions into the constituent cash flow components and aggregating these, dealers can attain an approximation of the residual market exposure of their overall derivatives portfolio. According to the Group of Thirty in 1993, "Dealers . . . typically manage the market risks of their derivatives activity on the basis of the net or residual exposure of the overall portfolio. A dealer's portfolio will contain many offsetting positions, which substantially reduce the overall risk of the portfolio, leaving a much smaller residual risk to be hedged."
Undesired residual market risk must be hedged. The hedge may take the form of synthetic option replication via dynamic hedging, with the dealer holding and shifting futures positions, say, in response to its changing market exposure. The Group of Thirty describes the dangers thus: "There are two main risks associated with a dynamic hedge. The cost of hedging may turn out to be greater than expected because actual volatility is greater than expected; and the hedge does not protect completely against gapped markets and prices may move significantly before positions can be adjusted. .*.*. Illiquidity can also be an issue for individual participants who hedge through a dynamic process." Sound familiar?
Rather than using underlying assets or futures to hedge their residual market exposures, dealers can use listed options. They will encounter essentially the same difficulties as with synthetic hedging, however. As listed options are generally of shorter maturity than OTC derivatives, and as the hedge position must be altered to reflect changes in net exposure, the option positions must be managed dynamically. The need for discrete rebalancing introduces the virtual certainty of replication errors and leaves the hedge portfolio open to the same dangers of market gaps and hidden costs that threaten dynamic hedging strategies.
In offsetting and hedging market exposures, issuers may find equity derivatives, particularly equity options, more problematic than currency or interest rate instruments, despite the fact that they make up only a small portion of all OTC contracts. For instance, it may be more difficult to find offsetting counterparties for equity options than for interest rate and currency swaps. Either side of an interest rate or currency swap, for instance, may be used to reduce risk, depending upon the nature of the user's cash inflows and outflows. In contrast, one side of an option trade is likely a speculative position. The ability to offset option positions may thus depend upon the presence of traders willing to take on that speculative risk.
Furthermore, the assets underlying equity derivatives are considerably more volatile than those underlying interest rate and foreign exchange rate derivatives.
Benjamin Weston, managing director of Credit Suisse Financial Products, notes in an August 1990 Institutional Investor article:
"If the underlying volatility of interest rates is a 1 and forex is a 2, then equity is about a 4. We manage our business on the basis of market-crash conditions, assuming that things can move 10 to 15 percent in a single day."
It may thus be harder to lay off the risk inherent in equity option positions than the lesser risk involved in rate-based options. And because they will certainly be more difficult to value, equity options may be more difficult to hedge, whether via dynamic trading strategies or listed options, hence more prone to replication failure.
Management of OTC derivatives requires complex mathematics and computer-based valuation and trading techniques. Operations are thus susceptible to computer and communications software breakdowns. They may also be difficult to track and control; often only the traders themselves can understand the complexity and risks of what they are doing. In an ironic twist to the story of portfolio insurance, in early 1993 Mr. O'Brien and his colleagues at Leland O'Brien Rubinstein began selling a software product that audits the "black boxes" that drive derivatives trading strategies.
Messrs. Hentschel and Smith, in the 1995 Journal of Financial Engineering, stress it is agency risks, including inappropriate incentives for traders, rather than credit risk that pose the greatest problem for derivatives market stability. Indeed, agency and oversight problems certainly were apparent in two of the most publicized cases involving derivatives-related losses. At Barings Bank, a single trader in the Singapore office lost $1.3 billion trading in futures on the Japanese market; the losses bankrupted the company. At Daiwa Bank in New York, a single trader lost an estimated $1.1 billion over an 11-year period. These disasters were enabled by the fact that the trader in each case was in charge of both the trading desk and the back-office operations that oversaw the trading operations.
Risks to markets
Market observers became very anxious about the potentially destabilizing effects of new derivatives products as the 1990s progressed. A number of governmental and quasi-governmental groups (including the Commodity Futures Trading Commission, the International Monetary Fund and the Group of Thirty) undertook studies and convened conferences to address this issue. Of particular concern was the possibility of difficulties to one derivatives user or dealer, or one market, causing, via the linkages created by derivatives themselves, widespread systemic failure. According to the International Monetary Fund: "The tendency for derivatives to create arbitrage opportunities and to strengthen the linkages between markets has increased the possibility that disruptions or increased uncertainty in these markets might spread over into other derivatives markets and into the cash markets more readily than in the past."
John Marshall, executive director of the International Association of Financial Engineers, argues to the contrary in a 1995 Journal of Financial Engineering:
"The reality . . . is that the derivatives markets have weathered a major stock market collapse, a sharp rise in interest rates, several currency crises, and the failures of several major financial institutions - all without anything remotely resembling a systemic crisis. My own view, after much study and contemplation, is that derivatives are not a source of significant systemic risk. Precisely the opposite. They are a prophylactic, a preventative for systemic risk. Through widespread use of derivatives for risk management purposes, individual firms, industries, and indeed the integrity of the system as a whole is increasingly insulated from the vagaries of the market."
Franklin Edwards, of the Center for the Study of Futures Markets at Columbia University, points out in a 1995 Journal of Financial Services Research that concern with the threat of derivatives seems to rest on four characteristics -the magnitude of dealer counterparty credit risk, concentration of OTC activity among a few dealers, extensive linkages between dealers and between dealers and markets, and a lack of regulation of non-bank dealers. He notes the U.S. General Accounting Office has found dealers' net credit exposure is less than 1% of the notional value of outstanding derivatives contracts; that the top eight U.S. dealers (seven banks, one security firm) account for only 33% of the worldwide notional value of derivatives held by dealers; that market linkages should increase liquidity and cushion local disturbances; and that non-bank dealers are well capitalized and, unlike banks, not beneficiaries of government deposit insurance, hence not a potential threat to government and taxpayer finances. Robert Easton, chief executive officer of the Commodities Corp., further notes in a Commodity Futures Trading Commission symposium, that derivatives market participants are sophisticated investors, as recognized in the Futures Trading Practices Act of 1992.
Peter A. Abken, in the 1994 Federal Reserve Bank of Atlanta Economic Review, cites the differential between revenue and losses after 10 years of derivatives trading ($35.9 billion in revenue, vs. cumulative losses of $19 million) and notes no commercial bank has failed as the result of derivatives trading. According to the CFTC's symposium: ".*.*. when insolvent financial institutions have been wound up in the last few years, including DFC New Zealand, Bank of New England, British & Commonwealth Bank, and Drexel Burnham, the derivatives activities were either transferred or closed out reasonably quickly. In fact, the derivatives books were closed out more rapidly and in a more orderly fashion than the firms' other traditional assets and liabilities could be liquidated."
The threat posed to the overall economy by the possible insolvency of a few derivatives dealers, however, might be secondary to the threat posed by derivatives-related trading to underlying markets. Already several incidents have signaled cause for concern. In 1994, for example, OTC dealers aggressively sold call options on European bonds as that market rose, hedging themselves by buying bonds; when prices turned down, dealers sold, adding to the considerable selling pressure from speculators who had bought on margin, in many cases with funds received from selling puts. A dealer at one European bank (quoted in the March 17, 1994, Wall Street Journal) described the result:
"People sold in the (bond) market until prices got pushed too far, then in the bond-futures markets, then in the swap market. And then they started trying to hedge in other instruments - like selling German bonds to hedge losses in Italian bonds - until all the markets were rolling along in the same black hole."
Equity markets may be at even greater risk than bond markets, given their much higher volatility and the potentially greater mismatch between buyers and sellers of risk-reducing equity derivatives. There already have been some episodes of exaggerated market volatility resulting from the "sons" of portfolio insurance. The Japanese market decline of the early 1990s has been linked to writers of Nikkei put warrants. It is probable that this slow and drawn-out crash was exacerbated by program selling in the index futures market.
"While the Nikkei put warrants weren't the cause of the Tokyo stock market's drop, . . . the computerized hedging programs backing them exacerbated the decline once it started and added to the market's volatility," according to an April 17, 1990, Wall Street Journal article.
Equity derivatives also can increase volatility on the upside.
Many of the "zero-cost" collars bought in early 1991 had proved to be expensive by the end of the year when the market soared through many investors' established caps. This might have caused an additional market rise as stocks that had been called away were bought back. A number of traders described the way the market received an extra kick upward as reminiscent of portfolio insurance.
In short, portfolio insurance as conducted with newly available derivatives such as OTC puts may pose problems for equity markets similar to those posed by synthetic insurance strategies. The extent of this danger will depend in part upon the size of the demand for insurance and the willingness of market participants to supply that demand. Here again we can detect unhappy correspondences to synthetic portfolio insurance.
First, the explosive growth in equity and other derivatives suggests to some a fad element similar to that detectable in the growth of synthetic insurance in the 1980s. In the Journal of Financial Services Research in 1995, Jerry Jordan, president and chief executive officer of the Federal Reserve Bank of Cleveland, noted:
"The explosive growth of OTC derivatives contracts conceivably could be classified as a temporary mania, particularly from the point of view of those whose mismanagement has produced spectacular losses. With hindsight, marginal private cost was apparently seriously underestimated. Continued rapid growth of derivatives contracts at the pace of the past several years would begin to raise the mania flag. Even in a global financial marketplace there must exist a finite limit to shiftable risk."
As with synthetic insurance, faddish pursuit of equity risk control via listed and OTC options and other instruments may lead to unwarranted dismissal of the inherent risks of stock investments and encourage higher than warranted commitments to stocks. As demand for stocks pushes prices away from fair valuations, prices become more susceptible to correction.
Whether a major correction will pose a significant threat to equity markets may depend upon the hedging designs of OTC dealers. If a decline in overall market prices forces a substantial amount of selling by OTC dealers, liquidity problems may result. Illiquidity may be exacerbated if, as with synthetic portfolio insurance, uncertainty about the identity and extent of hedging sales diminishes the willingness of value investors, speculators and others to take the buy side in declining markets:
"A paucity of reliable price information is viewed as potentially increasing liquidity strains because market-makers or other market users may be unwilling to commit capital to transactions without such data. The effects of price opacity upon liquidity may be particularly significant in the markets for highly customized, 'exotic' instruments or for instruments of longer maturities due to the unavailability of a meaningful exchange transaction price as a reference price," according to an October 1993 report by the CFTC.
In the absence of willing buyers, OTC dealers dependent on the ability to lay off equity positions in order to hedge their put exposures are particularly vulnerable to loss. Of course, losses on equity positions may be offset by gains on other derivative positions. And even a default by a single dealer is unlikely to cause the systemic collapse feared by regulators if, as Messrs. Hentschel and Smith contend, "defaults on derivatives contracts are approximately independent across dealers and over time."
As Mr. Jordan points out, however, "The risk levels of all financial contracts are interdependent in that they jointly depend on the state of the aggregate economy." Derivatives and dynamic strategies such as portfolio insurance may transfer risk, but they cannot eliminate it. The ability to transfer risk is finite. Strategies that presume otherwise are fated to fail, if not sooner then later.
Summary
Exchange-traded and OTC options have several advantages over synthetic portfolio insurance conducted via dynamic hedging. First, the option seller (backed, in the case of publicly traded options, by the exchange clearinghouse) guarantees the purchased level of protection will be there if needed. Second, the purchase price is known up front and not dependent upon subsequent volatility in the underlying asset. Third, to the extent they do not require selling into falling markets (or buying into rising markets), and to the extent the demand for protection is publicly revealed, options may pose less of a threat to market stability.
But the newer forms of portfolio insurance cannot, any more than synthetic insurance could, eliminate the risks of stock investing. OTC options in particular may pose hazards to insurance buyers, insurance issuers and the market as a whole.
Prices of privately negotiated OTC instruments are not publicly available to facilitate comparison shopping. Both users (and issuers) of these instruments must rely on theoretical models of questionable reliability. Insurance buyers thus face the risk of paying substantially more for portfolio protection than it is worth.
Issuers of OTC options face risks in the form of the market exposures they incur through their derivatives positions. Offsetting trades may be able to neutralize a large portion of the underlying market exposures of any given issuer, but some residual exposure is bound to remain.
Unless the issuer wants to maintain a speculative posture, it will have to hedge using listed options or dynamic hedging. Dynamic hedging, of course, exposes the issuer to the same problems that confronted institutional investors using synthetic portfolio insurance and may pose a similar threat to market stability.
Faddish pursuit of portfolio protection may lead to unwarranted dismissal of the risks inherent in stock investing and to a consequent increase in the demand for stock and to stock prices rising above fundamental levels. At the same time, extensive use of dynamic hedging by dealers attempting to hedge their option-related market exposures (especially given the lack of information about the volume of such hedging) may create the same information aggregation and liquidity problems that proved so catastrophic in 1987.
In such an environment, the possibility increases that major derivatives users or issuers may face insolvency. And today, with the linkages that derivatives have forged between firms and between markets, the problems may not be confined to a few firms, or even to the stock market alone. END
