4 October 2022

PDF version [648 KB]

Ian Zhou
Economic Policy Section

Executive summary

Derivatives are powerful financial instruments that play an important role in the capital markets. If they are mispriced or underregulated, they can amplify underlying systemic risks in the global financial system.

In 2003 Warren Buffett described derivatives as ‘financial weapons of mass destruction’. The 2008 Global Financial Crisis arguably proved the truth of his words because mispriced derivatives contributed to the systemic risks in the global financial system that eventually caused the crisis.

The 2008 crisis prompted a comprehensive international regulatory response, directed through the G20 forum (including Australia).[1] Since 2009 Australian regulators have been implementing the G20 reforms to improve transparency in the derivatives market.[2]

Notwithstanding the G20 reforms on derivatives trading, some analysts fear that major international banks are becoming too exposed to mispriced derivatives once again.[3] Furthermore, the strengthening of prudential regulations on banks (as outlined by Basel III) meant that the banks might find it cheaper to shift risk using derivative contracts.[4] This has sparked a public debate on whether there is sufficient government regulation of derivatives trading in Australia and other countries.[5]

As an open economy Australia is vulnerable to global risks that could trigger a ‘liquidity crunch’ or a reduction in international trade. This has implications for legislative changes implementing the G20 reforms, the resourcing and effectiveness of Australian regulatory agencies supervising derivatives trading and Australia’s engages with international partners in monitoring the progress of G20 reforms on the derivatives market.

 

Contents

Executive summary
Glossary
What is a financial derivative?
Why do investors and firms use derivatives?
What role do derivatives play in the financial markets?
How did mispriced derivatives contribute to the Global Financial Crisis?
Regulation of derivatives trading in Australia
Derivatives trading in the 2020s
Conclusion

 

Glossary

Acronyms	Definition
AIG	American International Group
ASIC	Australian Securities and Investments Commission
CDO	Collateralised debt obligation
CDS	Credit default swap
CLO	Collateralised loan obligation
MBS	Mortgage-backed security
OTC	Over the counter
TRS	Total return swap

What is a financial derivative?

A derivative is a contract between two parties that derives its value from the performance of an underlying asset. The underlying asset can be almost anything of value (most commonly commodities, stocks and bonds).

There are many types of derivatives. Traditional forms of derivatives such as options and forward contracts (illustrated in the example below) have existed for hundreds of years. Newer and more complex derivatives such as collateralised debt obligations or credit default swaps have grown enormously in recent decades, and now constitute a multi-trillion dollar worldwide market.[6]

Why do investors and firms use derivatives?

Derivatives are risk management tools. Investors and firms use derivatives primarily for two reasons:

1. to hedge against future price movements, reducing uncertainty; or
2. to speculate on future price movements, accepting greater risk exposure in exchange for the chance of greater profit. [7]

Using derivatives to hedge

Derivatives can make future cash flows more predictable, so many investors and firms use them to hedge against potential risk. In this regard, using derivatives is like buying an insurance policy that protects the investor against price uncertainty.

Hypothetical example of using derivatives to hedge against risk Andrew is a wheat grower and wants to sell his wheat in two weeks’ time. The current market price is $5 per kilogram, but it fluctuates daily. Andrew makes a ‘forward’ derivative contract with wheat buyer, Ian. The contract stipulates that Ian will buy 100 kilograms of wheat from Andrew at $5 per kilogram in two weeks’ time. With this contract in hand, Andrew protects himself against the potential risk that wheat prices may fall, knowing he will be able to sell his wheat at the guaranteed price of $5 per kilogram in two weeks. Similarly, Ian hedges against the risk that wheat prices may increase. This ‘forward’ contract between Andrew and Ian is an example of using derivatives as a hedge or risk management tool. The contract has made Andrew’s and Ian’s cash flows more predictable because Andrew knows he will receive $500 for 100 kilograms of wheat from Ian in 2 weeks’ time, and Ian knows he will receive 100 kilograms of wheat for $500, no matter how much the market price for wheat changes in the meantime. The value of the contract derives from the performance of wheat prices, hence the name derivative. If the market price for wheat unexpectedly increases to $8 per kilogram, then the derivative contract is more valuable to Ian because he will still be able to buy wheat at a bargain price of $5 per kilogram from Andrew, as stipulated by the contract. Conversely, if the price unexpectedly decreases, the contract is more valuable to Andrew, because he will be able to sell the wheat at an above-market price.

Using derivatives to speculate

Investors who are prepared to accept additional risk often use derivatives as a speculative tool. The purpose of speculation is to make a profit from betting that the prices of assets will move in a favourable direction. Complex derivatives allow investors to speculate on virtually anything.

Hypothetical example of using derivatives to speculate on price movement Currently milk is priced at $5 per litre, and Leah speculates that milk prices will go up in the near future. Leah decides to spend $500 to buy a ‘futures’ derivative contract from a derivatives exchange market. The contract says Leah will be entitled to receive 100 litres of milk from a third party in three months’ time. The derivative exchange is the ‘middleman’ for brokering and clearing this contract between Leah and the milk seller. If the price of milk increases, Leah’s contract for 100 litres will be worth more on the market than the $500 she invested, and she can sell it at a profit. If the price decreases, her contract will be worth less than $500, and she will lose money when she sells it. Two weeks pass and the market price for milk has increased to $8 per litre.[8] Leah decides to sell the contract to someone else (via the exchange) for $800. Someone is willing to buy Leah’s contract for $800 because that is the current market value of the underlying asset (ie milk) – provided the buyer has no reason to expect the price of milk to fall again before the three month term expires. Leah has made a $300 profit, not including fees and brokerage. In this case, rather than using derivatives to reduce risk, Leah has taken on more financial risk for the chance to speculate on the price movement of an asset. Leah never intended to take delivery of 100 litres of milk.

What role do derivatives play in the financial markets?

Derivatives serve an important ‘price discovery’ role in the economy as they can be used for establishing the prices of goods and services. When used as a hedge, derivatives provide investors with predictable cash flows and limit their risk exposure. Trading derivatives as a speculative tool can also provide liquidity and price signals in the financial markets.

Derivatives trading has opened up a wide array of financial markets for investors. For example, an Australian investor can speculate on the price of American soybeans or the value of the Canadian dollar by using derivatives.

On the other hand, mispriced and unregulated derivatives can pose a risk to the global financial system, as happened in the 2008 Global Financial Crisis.

How did mispriced derivatives contribute to the Global Financial Crisis?

The rise of collateralised debt obligations

Professor Michael Greenberger of the University of Maryland, among many others, believes that the extensive misuse of derivatives amplified the 2008 Global Financial Crisis – in particular, through the use of a type of derivative known as collateralised debt obligations (CDOs).[9]

Explainer: what is a collateralised debt obligation? CDOs are a type of derivative typically backed by a portfolio of loans (eg mortgages, bonds, credit cards debts and student loans). They are typically sold by banks to investors to free up more capital for the banks. Buyers of CDOs would pay a lump sum of money to the banks. In return, the buyers would receive a steady stream of income, based on the payments made on the various loans that were packaged into the CDOs. In other words, the value of CDOs derives from contracted loan and interest repayments by mortgage holders, credit card holders and other debtors. If these debtors defaulted on their loans (ie stopped making payments), the value of CDOs would fall and buyers of CDOs could suffer financial losses. As noted above, derivatives are primarily used either to hedge or to speculate; CDOs can serve either of these purposes. Buyers of CDOs speculate that debtors will not default and that the CDO buyers will therefore continue to receive steady income from their investment. Sellers of CDOs (eg banks) hedge against loan default risk and protect their downside, because they are essentially transferring the loan default risk to the CDO buyers.

CDOs grew in popularity in the United States in the early 2000s, with CDO sales increasing from US$30 billion in 2003 to US$225 billion in 2006.[10] According to the Reserve Bank of Australia, global CDO issuance increased sixfold from 2002 to 2006 (see Figure 1 below).

Figure 1: Issuance of CDOs increased significantly in the early 2000s

Source: Susan Black and Alan Rai, ‘Recent Developments in Collateralised Debt Obligations in Australia’, Reserve Bank of Australia Bulletin (November 2007): 5.

Fuelled by a housing market boom and an increase in mortgage uptake in the United States in the early 2000s, banks made handsome profits by packaging various types of loans into CDOs and selling them to investors.[11] This was usually done via a subsidiary company called a special purpose vehicle to shield the parental company from financial risk.[12]

There is a broad academic consensus that CDOs were frequently overvalued prior to 2008.[13] Additionally, the extent of banks’ exposure was opaque due to the complexity of these derivatives, so the extent of systemic risk went unnoticed.[14] Banks held CDOs on their ‘books’ before selling them to other investors (for example, pension funds). Banks also invested in each other’s CDOs. As such, the banking sector as a whole was financially exposed to a collapse in CDO value.

These problems were compounded by credit rating agencies’ underestimation of CDOs’ real risk.

Misconduct of credit rating agencies

Many academics, such as Professor Lawrence White of the New York University, argued that the misconduct of credit rating agencies contributed to the overvaluation of CDOs.[15]

Credit rating agencies are typically private companies paid by banks or investors to assess the risk levels of financial products. This includes determining the value and risk levels of derivatives – for example, in the 2000s, whether CDOs were backed by high-grade or subprime/riskier loans. However, for fear of losing their customers (including banks that wanted to sell CDOs), credit rating agencies often gave good credit ratings to CDOs backed by subprime/riskier loans.[16]

For example, some of the loans that were packaged into CDOs were known as NINJA (no income, no job, no assets) loans that carried a high risk of default.

These inflated credit ratings meant that many CDOs were overvalued. Buyers of CDOs were unaware of the default risk that these derivatives carried and assumed they were a good investment. Put simply, CDOs were no longer an effective risk management tool (which is the main purpose of derivative contracts) because investors were unaware of the real risk CDOs carried.

The table below shows examples of credit ratings and their corresponding risk levels.

Table 1: examples of credit ratings and their supposed risk level

Source: ‘Equifax Credit Ratings’, Equifax Australasia Credit Ratings Pty Ltd.

Potential consequences of incorrect CDO credit ratings Greg and Liz want to invest their money. They each pay a lump sum of money to a bank to purchase some CDO contracts. The bank has packaged a portfolio of its mortgage loans into mortgage bonds, and then repackaged the mortgage bonds into CDOs. The CDOs are divided into different tranches with different credit ratings, to cater to investors with different risk appetites. The bank’s CDO contracts stipulate that buyers will receive a steady income stream as long as mortgage holders meet the principal and interest repayments on their loans. If all the mortgage holders default on their loans, the buyers of CDOs will stop receiving this income stream. Greg is a cautious investor and only buys assets he considered to be safe. The CDOs Greg buys are all AAA rated (the highest possible credit rating). This means that credit rating agencies think the CDOs are backed by high-grade loans with very little default risk. Greg is unaware that the AAA-rated CDOs he is purchasing are in fact backed by subprime/riskier mortgage loans, because the credit rating agencies’ risk assessment is incorrect. Liz wants a higher return on her investment. The CDOs Liz buys are BBB rated. She knows they are riskier but offer higher returns. Six months pass, and all the mortgage holders default on their loans. Both Greg and Liz have stopped receiving an income stream from their CDOs and have lost their initial investments.

Regulation of derivatives trading prior to 2008

Despite sales of CDOs increasing exponentially in the early 2000s, CDO trading remained largely unregulated in the United States.

CDOs had traditionally been privately negotiated and traded between 2 parties without going through a centralised clearing exchange. Such privately negotiated derivatives are known as ‘over-the-counter’ (OTC) derivatives.[17] Many officials in the United States Government at the time believed that because OTC derivatives were mostly negotiated between sophisticated investors who knew what they were getting into, derivatives trading needed less regulation compared to other financial products.[18]

In 1998, the former Federal Reserve Chairperson Alan Greenspan told Congress that ‘regulation of derivatives transactions that are privately negotiated by professionals is unnecessary’.[19] In 2000, Congress passed the Commodity Futures Modernization Act that excluded derivatives trading from regulatory oversight.[20]

Had CDO trading been conducted through centralised clearing exchanges, United States regulators may have had an easier time overseeing the derivatives market and stopping questionable trading practices.[21] Instead, the private, bilateral nature of OTC derivatives meant there was a lack of transparency concerning the risk profile of market participants in the derivatives markets.[22]

Building a ‘house of cards’

In 2005 Professor Raghuram Rajan, the former Chief Economist at the International Monetary Fund, warned that perverse incentives (coupled with the wrong monetary policy) could lead banks and investment firms to take excessive risks.[23]

There were strong incentives for investment managers at banks and investment firms to generate profits because their pay or bonuses were largely performance based. As such, Professor Rajan was concerned that managers were incentivised to use innovative financial instruments, like derivatives, to take excessive risks with company money in the hope of generating high returns, which could then lead to a ‘catastrophic meltdown’ of the financial system.[24]

Professor Nouriel Roubini of New York University described the perverse incentive culture of investment managers:

People were essentially being rewarded for taking massive risks. In good times, they generate short-term revenues and profits and therefore bonuses. But that’s going to lead to the firm to be bankrupt over time. That’s a totally distorted system of compensation.[25]

In the early 2000s, major banks traded an increasing number of mortgage-backed securities (MBSs) and derivative contracts that repackaged MBSs. This increased their short-term profits but also significantly increased their risk exposure, partially because they had incorrectly assessed the risk levels of the derivatives.[26]

Put simply, derivatives were one of the financial tools that allowed investment managers to take on excessive financial risks (for the purpose of generating short-term revenues) without tipping off the regulatory authorities.  

In addition to CDOs, banks and investors used other complex derivatives such as synthetic CDOs and credit default swaps (CDSs) to make ‘side bets’ speculating on whether the value of CDOs would rise or fall.[27]

Explainer: what is a credit default swap (CDS)? CDSs are a type of derivative contract that functions like an insurance policy. Suppose Jonathan has lent a large sum of money to a borrower. Jonathan purchases a CDS on the loan by making a series of cash ‘insurance premium’ payments to an insurance company. In return, the insurance company promises to compensate Jonathan if the borrower defaults on the loan. The key difference between a real insurance policy and a CDS is that a CDS can also be used by speculators to insure against a borrower default on somebody else’s loan. Suppose Melanie, who is not involved in Jonathan’s loan at all, decides to purchase a CDS on Jonathan’s loan. If the borrower defaults on Jonathan’s loan, Melanie also gets paid by the insurance company. In other words, Melanie has made a ‘side bet’ speculating that the borrower will default on Jonathan’s loan. Journalist Matthew O’Brien from The Atlantic has compared CDSs to buying a car insurance policy on somebody else’s car in which you only get paid if that person gets into a car crash.[28] The underlying message here is that CDSs create perverse incentives. For example, because Melanie has purchased a CDS on Jonathan’s loan, Melanie presumably hopes that Jonathan’s loan goes bad, so she can get paid by the insurance company. Melanie may even take actions to ensure that the borrower defaults on Jonathan’s loan. Pope Francis said: The spread of such a kind of contract without proper limits has encouraged the growth of a finance of chance, and of gambling on the failure of others, which is unacceptable from the ethical point of view.[29]

Banks and investors used CDSs to hedge against the potential risk of loan default. While this decreased the risk exposure of investors, it significantly increased the risk exposure of major insurance companies.

American International Group (AIG), one of the world’s largest insurance companies, was a prolific underwriter and seller of CDSs. Many investors purchased AIG’s CDSs because they had lent out money and wanted to be compensated if the loans went bad. Many speculators, who were not themselves parties to the loans, also purchased CDSs to speculate that the loans would go bad.

As OTC derivative markets were largely unregulated, in theory AIG could underwrite and sell unlimited CDSs even if it did not have enough collateral to pay out the CDSs when loans went bad.

In 2008, the New York Times featured an article that reported AIG’s Financial Products Division had underwritten and sold CDSs worth $500 billion (US dollars), and that the company was receiving as much as $250 million a year in income from CDS ‘insurance premiums’.[30] Many of these CDSs were to provide insurance to financial institutions holding CDOs, in case loan borrowers defaulted.

In other words, the investment managers at AIG took excessive risks and miscalculated the chance of a mass loan default, and therefore grossly mispriced the CDSs they had underwritten.[31]

It is unclear whether the senior executives of the AIG knew the company had sold CDSs in excess of its ability to pay out in the event of a mass loan default. Nevertheless, the investment managers’ focus on short-term gains and a lack of regulatory oversight meant that very few people at AIG had the incentives to speak out against excessive risk-taking.

Through holding a large volume of mispriced derivatives on their balance sheets, major banks and insurance companies became extremely exposed to the potential risk of a mass default on subprime mortgages and other related loans.

Professor Frank Partnoy of the University of California explained how derivatives amplified risk exposure, spreading it throughout financial markets:

If you were a homeowner with a risky subprime mortgage loan, CDO arrangers might put together a hundred side bets on whether you would default. Through credit default swaps, a hundred investors around the world could be exposed to the risk that you might not make your next monthly payments.[32]

The collapse of a ‘house of cards’

It is worth repeating that a derivative contract derives its value from an underlying asset, with the asset underlying a CDO in the cases above being an income stream from subprime mortgage repayments. If this asset becomes worthless – for example because the borrower defaults on the loan – then the derivative CDO also becomes worthless.

When the American housing market slowed down in 2007–08 after a two-decade housing boom, many mortgage holders started to default on their loans, and the number of home foreclosures increased substantially.[33] It became increasingly evident that the value of CDOs reliant on subprime mortgage repayments had been vastly overstated.

While some banks did not know the exact extent of the losses they faced from holding these overvalued CDOs, other banks actually attempted to sell overvalued CDOs to unsuspecting investors to mitigate their losses.[34] The resulting fear and uncertainty made banks and investors reluctant to lend money, contributing to a global ‘liquidity crunch’ that exacerbated the 2008 Global Financial Crisis.[35]

To ‘bail out’ AIG and some major banks, the United States Government implemented the Troubled Asset Relief Program to purchase up to $700 billion in distressed assets from these companies to keep them solvent.[36]

In 2009, President Barack Obama said:

Under these circumstances, it's hard to understand how derivative traders at AIG warranted any bonuses, much less $165 million in extra pay. How do they justify this outrage to the taxpayers who are keeping the company afloat?[37]

Regulation of derivatives trading in Australia

Why is regulation of derivatives trading so challenging?

Regulation of derivatives trading is challenging because governments may not always have adequate information on the derivatives market. Economist Vania Stavrakeva argues:

Derivatives are much more complicated contracts than regular loans, bond and equity purchases and have very different accounting standards. In order to estimate the exposure of banks to systemic crises caused by derivative positions, regulators will need both bank specific transaction level data and fairly complex value at risk models …

Of course one should not forget that derivatives can also improve welfare by allowing firms and financial institutions to hedge risk and by improving risk sharing. Therefore, one needs to be careful not to overregulate.[38]

Implementation of G20 reforms

The 2008 Global Financial Crisis prompted a comprehensive international regulatory response, directed through the G20 forum (including Australia).[39] G20 leaders agreed in September 2009:

All standardised OTC derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by the end of 2012 at the latest. OTC derivative contracts should be reported to trade repositories. Non-centrally cleared contracts should be subject to higher capital requirements.[40]

As noted, the lack of data on derivatives trading has made it more difficult for regulatory agencies to adequately supervise the derivatives market. Before the 2008 global financial crisis, regulators in Australia generally only had access to highly aggregated data to understand the OTC derivatives market, and the 2008 crisis highlighted that these aggregated data are ‘insufficient to shed light on the vulnerabilities that can exist when there is a web of derivative transactions between a large variety of firms’.[41]

Consequently, the Australian Government has introduced a suite of legislative changes designed to improve transparency and reduce systemic risk associated with derivatives trading. The legislative changes also align with Australia’s commitment to implement the Basel III agreement that prescribes banks’ capital and liquidity requirements for derivatives transactions.

For examples, the Corporations (Derivatives) Determination 2013 empowers the Australian Securities and Investments Commission (ASIC) to make rules imposing reporting requirements on a range of derivatives.[42] The ASIC Derivative Transaction Rules (Reporting) 2013 set out the rules for reporting derivative transactions to trade repositories. The ASIC Derivative Transaction Rules (Clearing) 2015 impose a mandatory central clearing regime for OTC interest rate derivatives denominated in major currencies. These reforms have greatly increased the information that regulators have about the Australian derivatives market.[43]

On the other hand, some stakeholders warn the risks of overregulation, especially considering that the COVID-19 pandemic placed significant operational burden for market participants. For example, the brokerage firm Pepperstone has said:

… we are concerned that some of the requirements in CP 322 are overly stringent, and do not allow for investors who understand and accept the risks associated with trading our products to trade the way they require. We are concerned that this restriction on investors’ freedom of choice will result in them seeking alternatives outside of Australia, even if it means trading outside of a regulated jurisdiction. [44]

Multilateral cooperation

Although Australian regulators have been implementing G20 reforms to reduce systemic risks in the financial sector, as an open economy Australia remains exposed to risks in the world economy. As such, Australia has an interest in promoting multilateral efforts to strengthen the international institutions and mechanisms needed to manage these risks.

Australia is a member of the Financial Stability Board (FSB), an international body that monitors the stability of the global financial system and publishes an annual progress report on the implementation of OTC derivatives reforms. Since 2009 Australian regulators have worked with other members of the FSB to resolve cross-border issues that have arisen in the implementation of OTC derivatives reforms.[45]

Derivatives trading in the 2020s

Bespoke CDOs

Today, derivatives trading is widespread and accessible. An increasing number of equity and even cryptocurrency exchanges are offering a wider range of derivatives.[46] According to a report by the World Federation of Exchanges, more than 32 billion derivative contracts were traded in 2019.[47]

Trading volumes in CDOs decreased significantly after 2008.[48] However, more recently, banks have once again been increasing their CDO sales. Due to CDOs’ negative connotations, banks have renamed these derivatives ‘bespoke tranche opportunities’ or ‘bespoke CDOs’.[49] These new bespoke CDOs are predominantly purchased by hedge funds and other institutional investors seeking higher returns.

In April 2019, Reuters reported that:

Trading volumes in synthetic collateralised debt obligations linked to credit indexes are up 40% this year, according to JP Morgan, after topping US$200bn in 2018 on the back of three years of double-digit growth. Meanwhile, analysts predict more than US$100bn in sales of bespoke synthetic CDOs in 2019 following an estimated US$80bn of issuance last year.[50]

Banks have argued that the new bespoke CDOs are now backed by safer loans rather than subprime mortgages.

Total return swaps

In March 2021, Bill Hwang, the founder of Archegos Capital Management, used a type of OTC derivative known as a total return swap (TRS) to indirectly invest in the US stock market. The TRS contracts significantly increased Archegos Capital’s risk exposure, because TRSs are designed to allow investors to trade on margin by using borrowed money (illustrated in the example below).[51] Archegos Capital lost an estimated US$20 billion in 2 days and caused its lenders to lose tens of billions.[52]

Hypothetical example of using total return swaps (TRSs) to speculate Shannon wants to buy 100 shares of a company’s stock, but only has enough money for 20 shares. Shannon also does not want her friends to know she invests in the stock market. Shannon decides to enter into a TRS contract with a bank. The TRS contract stipulates that the bank will purchase 100 shares of the company’s stock. If the share price increases, then Shannon will receive the profit (minus bank fees and brokerage). This means the bank has essentially purchased 100 shares of the company’s stock on behalf of Shannon. Note that Shannon does not technically own the shares; the bank does. This gives Shannon the anonymity she desires while also allowing her to profit from a rise in the share price. The bank is willing to enter into the TRS contract with Shannon because she has put up her money (which is enough to buy only 20 shares) as collateral. If the share price falls by 20% and wiped out Shannon’s initial investment, the bank will ask Shannon to put up more collateral (known as a margin call). If Shannon cannot afford to put up more collateral, the bank will liquidate her position by seizing the collateral and forcibly selling the shares at a 20% loss. This means Shannon will lose her initial investment and 100 shares. In theory, the bank should not suffer any loss, because it would have sold 100 shares and seized Shannon’s initial investment/collateral (which was enough to purchase only 20 shares) to make up the 20% fall in the share price.[53] Fortunately for Shannon, after she enters into the TRS contract with the bank, the share price increases by 20%. Shannon tells the bank to sell the shares and concludes her TRS contract. Because Shannon has been trading on a leveraged position by using the TRS, this means that although the share price increased only by 20%, Shannon has doubled her initial investment, excluding bank fees and brokerage. In conclusion, margin trading by using TRS amplifies the potential gains and losses for investors.

Because Archegos Capital was a relatively low-profile family office, it was not subject to the same regulatory scrutiny as major hedge funds. This allowed Archegos Capital to enter into TRS contracts with 6 major investment banks simultaneously without disclosing to any single bank or the regulatory authority that it had multiple TRS contracts with other banks.[54] One commentator described Archegos Capital’s decisions as:

Imagine you go to four mates separately, borrow £1000 from each without telling the other, and go to a casino and put it [sic] all that money on red.[55]

In other words, the TRS allowed Archegos Capital to trade on margin and take a highly leveraged position on selected stocks. When the stock price fell and Archegos Capital could no longer afford to put up the collateral to maintain its leveraged position, it caused a stock fire sale that further depressed the stock price. This wiped billions of dollars off the stock market and resulted in ‘one of the single greatest losses of personal wealth in history’.[56]

The Financial Times featured an article that commented on the potential destructive power of derivatives:

The Archegos Capital debacle has exposed the hidden risks of the lucrative but opaque equity derivatives business through which banks empower hedge funds to make outsize [sic] bets on stocks and related assets.

The soured wagers made by Bill Hwang’s family office have triggered significant losses at Credit Suisse and Nomura, underscoring how these tools can cause a chain reaction that cascades across financial markets.[57] [emphasis added]

The collapse of Archegos Capital has prompted financial regulators around the world to investigate their risk control measures.[58] For example, the Financial Times reported that Hong Kong’s central bank and financial regulator are planning to use centralised trade databases to identify excessive risk-taking by banks and investment funds trading derivatives on Hong Kong markets.[59]

Conclusion

Derivatives are powerful financial tools that can help investors to manage risk and limit investment exposure. However, derivatives can also lead to excessive speculative trading and significantly increase investors’ risk exposure.

On a large enough scale, mispriced derivatives can endanger the entire financial system. Like any other powerful tool, derivatives need to be properly monitored and regulated. Consequently, it is important that Australian regulatory agencies are effective in carrying out their supervision of derivatives trading, complemented by continued promotion of multilateral cooperation to implement derivatives market reforms.

 

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[1].   Carl Schwartz, ‘G20 Financial Regulatory Reforms and Australia’, Reserve Bank of Australia Bulletin, September quarter 2013.

[2].   The Australian Securities and Investments Commission (ASIC) and the Australian Prudential Regulation Authority (APRA) are the two most prominent regulators of the Australian financial services industry. This is commonly referred to as the ‘Twin Peaks’ model of financial regulation. In addition to the twin regulators (ASIC and APRA), other agencies such as the Reserve Bank of Australia, the Treasury, and the Council of Financial Regulators also play a role in the regulation of Australia’s financial services industry.

[3].   Daniel Tischer, Adam Leaver and Jonathan Beaverstock, ‘Collateralised loan obligations: why these obscure products could cause the next global financial crisis’, The Conversation, 22 September 2021.

[4].   Vania Stavrakeva, ‘Derivative regulation: Why does it matter?’, Think at London Business School, 1 September 2013.

[5].   Mayra Valladares, ‘Leveraged loans and collateralized loan obligations are riskier than many want to admit’, Forbes (online), 22 September 2019.

[6].    ‘About derivatives statistics’, Bank for International Settlements.

[7].   ‘Exposure’ in finance means the amount of money an investor stands to lose if the investment fails.

[8].   Typically a person can choose to sell a futures contract at any time before the contract expiry or ‘delivery’ date.

[9].   Michael Greenberger, ‘The Role of Derivatives in the Financial Crisis’, Testimony of Michael Greenberger before Financial Crisis Inquiry Commission Hearing, 30 June 2010, 1.

[10]. Sergey Chernenko, Samuel Hanson and Adi Sunderam, ‘The Rise and Fall of Demand for Securitizations’, National Bureau of Economic Research Working Paper 20777, (December 2014), 1. United States Government, ‘The Financial Crisis Inquiry Report’, Financial Crisis Inquiry Commission, 130.

[11]. Adrian Blundell-Wignall, ‘Structured Products: Implications for Financial Markets’, OECD Journal Financial Market Trends 2, (2 November 2007): 27–57, 33.

[12]. Janet Tavakoli, ‘Structured Finance: Uses (and Abuses) of Special Purpose Entities’. Presentation to the Federal Reserve Conference on Bank Structure and Supervision, Chicago, May 2003.

[13]. Robert Jarrow, ‘The Role of ABS, CDS and CDOs in the Credit Crisis and the Economy’, in Alan Blinder, Andrew Loh and Robert Solow, eds, Rethinking the Financial Crisis, (New York: Russell Sage Foundation, 2012), 210–234.

[14]. Sirio Aramonte and Fernando Avalos, ‘Structured finance then and now: a comparison of CDOs and CLOs’, Bank for International Settlements Quarterly Review, (22 September 2019), 13. See the definition of ‘exposure’ in note 6.

[15]. Lawrence White, ‘The credit-rating agencies and the subprime debacle’, Critical Review: A Journal of Politics and Society 21, no. 2 (13 July 2009): 389–399.

[16]. Mark Rom, ‘The Credit Rating Agencies and the Subprime Mess: Greedy, Ignorant, and Stressed?’ Public Administration Review 69, no. 4 (6 July 2009): 640–650, 641.

[17]. Over-the-counter derivatives .usually have a higher credit risk, where one or both parties to the contract may potentially default on the terms of the agreement.

[18]. US Department of Treasury, ‘Over-the-Counter Derivatives Markets and the Commodity Exchange Act’, Report of the President’s Working Group on Financial Markets (November 1999): 15.

[19]. Federal Reserve Board, ‘The regulation of OTC derivatives’, testimony of Chairman Alan Greenspan before the Committee on Banking and Financial Services, U.S. House of Representatives, 24 July 1998.

[20]. Lynn Stout, ‘How Deregulating Derivatives Led to Disaster, and Why Re ­Regulating Them Can Prevent Another’, Cornell Law Faculty Publications Paper 723, no. 1 (July 2009): 7.

[21]. Ron Hera, ‘Forget about housing, the real cause of the crisis was OTC derivatives’, Business Insider Australia, 12 May 2010.

[22]. Bernard Pulle, ‘Over-the-counter derivatives—high risk investments in a largely unregulated market’, Parliamentary Library Briefing Book: Key Issues for the 44th Parliament, (Canberra: Parliamentary Library, 2013), 42–43.

[23]. Raghuram Rajan, ‘Has financial development made the world riskier?’, Proceedings - Economic Policy Symposium - Jackson Hole, Federal Reserve Bank of Kansas City, (August 2005): 313–369, 315.

[24]. Rajan, 318.

[25]. Nouriel Roubini, ‘Insider Job’, transcript, Sony Pictures Classics, October 2010.

[26]. Susan Wachter, Adam Levitin and Andrey Pavlov, ‘Bad and Good Securitization’, Wharton Real Estate Review 13, no. 23 (2009): 23–34, 33.s

[27]. John Authers, ‘Why bets on synthetic CDOs must be banned’, Financial Times, 24 April 2010.

[28]. Matthew O’Brien, ‘How to Make Money for Nothing Like Wall Street’, The Atlantic, 25 October 2013.

[29]. Joe Rennison, ‘Pope says credit default swaps are unethical’, Financial Times, 18 May 2018. The original bulletin released by the Holy See Press Office is provided here.

[30]. Gretchen Morgenson, ‘Small unit in London pushed AIG into the skid that nearly destroyed it’, New York Times, 28 September 2008.

[31]. If AIG had correctly calculated the chance of a mass loan default, presumably it would have charged higher insurance premiums for the CDSs it issued. As an analogy, if an insurance company knows a customer is a bad driver, it charges them a higher premium for car insurance.

[32]. Frank Partnoy, ‘Frank Partnoy: Derivative Dangers’, NPR Fresh Air program, transcript, National Public Radio, 25 March 2009.

[33]. Susan Wachter and Benjamin Keys, ‘The Real Causes — and Casualties — of the Housing Crisis’, Knowledge at Wharton podcast, transcript, 13 September 2018.

[34]. Jonathan Stempel, ‘Goldman loses bid to end lawsuit over risky CDO’, Reuters, 22 March 2012.

[35]. Thomas Hogan, ‘What Caused the Post-crisis Decline in Bank Lending?’, Rice University’s Baker Institute for Public Policy: Issue Brief 01.10.19, 1.

[36].  ‘Troubled Assets Relief Program (TARP)’, U.S. Department of Treasury.

[37]. Jeff Mason and David Alexander, ‘Outraged Obama goes after AIG bonus payments’, Reuters, 17 March 2009.

[38]. Vania Stavrakeva, ‘Derivative regulation: Why does it matter?’, Think at London Business School, 1 September 2013.

[39]. Carl Schwartz, ‘G20 Financial Regulatory Reforms and Australia’, Reserve Bank of Australia Bulletin, September quarter 2013.

[40]. G20 Information Centre, G20 Leaders Statement: The Pittsburgh Summit, 24–25 September 2009.

[41]. Duke Cole and Daniel Ji, ‘The Australian OTC Derivatives Market: Insights from New Trade Repository Data’, Reserve Bank of Australian Bulletin, 21 June 2018.

[42]. Australian Securities and Investments Commission, ‘Regulatory Guide 251: Derivative transaction reporting’, 5.

[43]. Duke Cole and Daniel Ji, ‘The Australian OTC Derivatives Market: Insights from New Trade Repository Data’, Reserve Bank of Australian Bulletin, 21 June 2018.

[44]. Pepperstone, submission to ‘ASIC Consultation Paper 322 Product Intervention: OTC binary options and CFDs’, 1.

[45]. Carl Schwartz, ‘G20 Financial Regulatory Reforms and Australia’, Reserve Bank of Australia Bulletin, September quarter 2013.

[46]. Justina Lee, ‘How Derivatives Amp Up Already Heady Crypto Markets’, Bloomberg News, 17 July 2021.

[47]. World Federation of Exchanges, ‘The WFE’s Derivatives Report 2019’, 26 June 2020, 3.

[48].  Paul Davies and Stacy-Marie Ishmael, ‘CDO issuance ‘to drop 60%’ in 2008’, Reuters, 8 January 2008.

[49]. ‘Bespoke’ also refers to the fact the buyers can now customise the CDOs to fit their specific risk appetite. The appeal of bespoke CDOs is that they typically offer investors higher returns than can be found in the global bond markets.

[50]. Christopher Whittall, ‘Banks, investors pile back into synthetic CDOs’, Reuters, 30 April 2019.

[51]. Margin trading refers to the practice of using borrowed money to buy and sell a financial asset.

[52]. Leo Lewis, Tabby Kinder and Owen Walker, ‘Credit Suisse and Nomura warn of losses after Archegos-linked sell-off’, Financial Times, 30 March 2021.

[53]. The reality may be more complicated, a bank could suffer losses if it tries to sell too many shares too fast which will further drive down share prices.

[54]. Matt Scuffham, John Revill and Makiko Yamazaki, ‘Global banks brace for losses from Archegos fallout’, Reuters, 29 March 2021.

[55]. Kieran King, ‘The Archegos Saga and Total Return Swaps Explained’, YouTube, 8 April 2021.

[56]. Katherine Burton and Tom Maloney, ‘One of world’s greatest hidden fortunes is wiped out in days’, Sydney Morning Herald, 1 April 2021.

[57]. Robert Armstrong, ‘Archegos debacle reveals hidden risk of banks’ lucrative swaps business’, Financial Times, 1 April 2021.

[58]. Tabby Kinder, ‘Hong Kong plans new risk controls to prevent Archegos-style collapse’, Financial Times, 31 August 2021.

[59]. Kinder, Financial Times.

 

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