Derivatives (financial)

Derivatives (financial), financial instrument whose value is based on an underlying asset. For example, futures contracts, also called futures, are a derivative. Futures are contracts to buy or sell commodities. The commodities are assets that have real value, while the futures derive their value from the commodities they are based on.

Another type of derivative is the stock option. Stock options give an investor the right to buy or sell shares of a certain stock at a specific price. The value of the option rises and falls with the price of the stock, the underlying asset. There are many other, more complex derivatives. Some are based on international currencies, some on changes in interest rates, others on combinations of several underlying assets.

Derivatives allow investors to hedge when buying a certain asset. Hedging is a way to protect against a loss in value of an investment. For example, if the holder of a certain stock is concerned that the stock price will fall, he or she might purchase a type of option whose value will increase if the stock falls in price. The option thus provides a kind of insurance against loss for the stockholder.

Derivatives are useful as tools for hedging. However, when used for speculative investing—that is, buying investments in hopes of selling them quickly for a profit—they hold a great deal of risk. Derivatives have a great amount of leverage. In other words, an investor can control assets worth far more than the original investment. As a result, an investor can also gain profits or incur losses larger than the investment.

Some types of derivatives are regulated by the government, while others are not. Derivatives that are traded on exchanges, such as commodity futures, fall under government regulation, whereas derivatives traded privately are unregulated. Many prominent investors have stayed away from this type of unregulated derivative and have advised others to do the same. The famous investor Warren Buffett once described unregulated derivatives as “financial weapons of mass destruction, carrying dangers that … are potentially lethal.” Strikingly similar language came from the investment banker Felix Rohatyn, who called derivatives potential “hydrogen bombs.” A report by the International Monetary Fund referred to derivatives as “ticking time bombs.” The financier George Soros explained that “we don’t really understand how they work.”

Part of the reason that derivatives became so worrisome to some investors derived from the vast amount of money involved in the unregulated type. The derivatives market began increasing rapidly in the 1990s and early 21st century. As measured by the notional value—that is, the amount of the underlying asset on which the derivative is based—the derivatives market amounted to $865 billion in 1987. By 2008 it had soared in value to $531 trillion, an increase from $106 trillion in 2002 and from $37 trillion in 1998.

Derivatives received wide publicity in 1994 when the treasurer of Orange County, California, drove the county into bankruptcy by trading unsuccessfully in derivatives, costing the county more than $1.6 billion. The same year the General Accounting Office (now called the Government Accountability Office) released the results of a study of the risks posed by derivatives. The report found “significant gaps and weaknesses” in regulatory oversight of derivatives. In testimony before Congress the head of the GAO remarked that the failure of derivatives “could cause liquidity problems in the markets and could also pose risks to others, including federally insured banks and the financial system as a whole.” The GAO head predicted that such failures could lead to a “financial bailout paid for or guaranteed by taxpayers.”

As a result of congressional hearings, Arthur Levitt, the chair of the Securities and Exchange Commission, urged a number of major investment banks to do something about the lack of oversight, transparency, and accountability in derivatives trading. The firms responded with a plan for self-regulation. A proposal in 1997 to bring all derivatives under some type of regulation met with opposition from Federal Reserve chair Alan Greenspan and Secretary of the Treasury Robert Rubin. The proposal came from Brooksley Born, the head of the Commodity Futures Trading Commission (CFTC), the federal agency that oversees options and futures.

The warnings of the possible need for a bailout soon came true. In 1998 the Federal Reserve mediated a deal in which a number of banks extended about $3.6 billion to a hedge fund known as Long-Term Capital Management, which was heavily invested in derivatives. The Federal Reserve arranged the bailout due to worries that a failure of the hedge fund could have global financial repercussions. The bailout of Long-Term Capital Management appeared to strengthen Born’s resolve to regulate derivatives, but Greenspan, Levitt, and Rubin persuaded Congress to freeze the CFTC’s regulatory authority for six months. The following year, at the recommendation of Greenspan and Rubin, Congress permanently deprived the CFTC of any regulatory authority over derivatives.

Derivatives were also at the center of the Enron scandal in the early part of the 21st century. The Enron Corporation created derivatives involving electricity, enabling investors to hedge against a decline in the value of electric utility contracts. Although the criminal investigations that resulted in indictments of Enron officials focused on fraudulent accounting practices, some critics at the time warned that derivatives should be brought under regulation to prevent further abuse. The U.S. Congress, however, decided not to regulate derivatives when, in response to the Enron scandal, it passed the Public Company Accounting Reform and Investor Protection Act of 2002, also known as the Sarbanes-Oxley Act for the members of Congress who sponsored the law.

Critics were quick to remind members of Congress of the need for regulating derivatives during the financial crisis that began six years later in 2008 with the bailout of the American International Group, Inc. (A.I.G.), the world’s largest insurance company. A unit of the company specializing in derivatives single-handedly brought A.I.G. to the verge of bankruptcy, prompting an $85-billion attempt by the Federal Reserve to rescue the company. The A.I.G. unit, known as A.I.G. Financial Products and based in London, England, had invested heavily in derivatives known as credit default swaps, which supposedly enabled investors to hedge against credit defaults.