Derivatives: Practices and Principles
Global Derivatives Study Group ISBN 1-56708-090-1 July 1993 Introduction Derivatives have fundamentally changed financial management by providing new tools to manage risk. As the use of derivatives has grown rapidly in the past 15 years, they have moved into the mainstream of finance. Yet many, both inside and outside of the financial industry, remain uncomfortable with derivatives activity. They see it as complex and obscure, potentially subject to abuse that might lead to the failure of individual firms or even to a crisis in the financial system. This Study recognizes and addresses these concerns by explaining derivatives and their uses and by formulating and disseminating recommendations about their management. The distinguishing feature of this Study is the practical character of its contents. Other studies of derivatives have been conducted by academics or supervisors; this Study was conducted largely by market participants. Why Derivatives Matter In general terms, a derivatives transaction is a contract whose value depends on (or "derives" from) the value of an underlying asset, reference rate, or index. This Study focuses on global "over-the-counter" (OTC) derivatives--those privately negotiated contracts provided directly by dealers to end-users, as opposed to the standardized contracts (such as futures) sold on exchanges. The main over-the-counter derivatives include swaps, forwards, and options, based upon interest rates, currencies, equities, and commodities. By any measure, derivatives are a major financial activity. Some have even portrayed it as a multi-trillion dollar business dwarfing activity in other financial markets. But a more careful comparison reveals that, while derivatives activity is growing rapidly, its size remains modest in relation to foreign exchange, bonds, or equities. What makes derivatives important is not so much the size of the activity, as the role it plays in fostering new ways to understand, measure, and manage financial risk. Through derivatives, the complex risks that are bound together in traditional instruments can be teased apart and managed independently, and often more efficiently. The results can benefit a wide variety of institutions. For many that issue securities, and for many that invest, derivatives can save costs and increase returns while broadening the range of funding and investment alternatives. For them and others, derivatives can reduce the risk of loss. And for financial institutions, derivatives can be a source of strength because they reinforce existing activities with clients, and help to build diversified credit portfolios. Derivatives and Risk Derivatives help to manage risk in new ways--an important economic function. Yet the risks involved in derivatives activities are neither new nor unique. They are the same kinds of risks found in traditional financial products: market, credit, legal, and operational risks. Because over-the-counter derivatives are customized transactions, they often assemble risks in complex ways. This can make the measurement and control of these risks more difficult and create the possibility of unexpected loss. Banking supervisors have conducted several studies into the implications of derivatives for the financial system. None of these studies concluded that derivatives significantly increase systemic risk, but neither did they find cause for complacency. For derivatives activity to grow and prosper, those who take part in it--whether as dealers, end-users, or both--should continue laying a strong foundation of good management practice. They also should provide the public with information that will allay unjustified fears by demystifying this activity. And participants should discuss openly with legislators, supervisors, and regulators, ways to further strengthen the current institutional framework. These steps are both appropriate and sufficient to address the systemic and other concerns about derivatives activity. Without minimizing the significance of these concerns, this Study does not conclude that any fundamental changes in the current regulatory framework, such as separate regulation of this activity, are needed. Separate regulation of global derivatives would be at cross-purposes with the existing framework of supervision, with its focus on the common risks contained in derivatives and traditional instruments. There is also a danger in imposing regulatory formulas that inhibit new product innovation or discourage firms from developing the individualized, robust risk management systems on which they should rely. The Global Derivatives Study This Study consists of the Recommendations, an Overview of Derivatives Activity, and three Appendices: The Recommendations The Study offers 20 recommendations to help dealers and end-users manage derivatives activity and continue to benefit from its use. The Study also recommends four ways that supervisors and regulators, for their part, can help the financial infrastructure keep up with derivatives activity. The Overview of Derivatives Activity The Overview section of this Study explains in relatively plain language what derivatives are, the needs they serve, their risks, and their relationship to traditional financial instruments. The Overview is intended to promote understanding and discussion among the growing number of people--in financial institutions, other corporations, and official bodies--that have an interest in the subject. The Appendices Three separately bound volumes of appendices contain the Study's detailed background material, which should be of special interest to professionals involved in various aspects of derivatives.
By contributing to the public understanding of the nature and potential of derivatives, and by providing guidance on principles of good management, the authors of this Study hope to add to the soundness and utility of these instruments.
The Recommendations
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