TOOLS FOR MANAGING RISK, OR WEAPONS OF MASS DESTRUCTION?
By Gordon Platt
As companies looked to hedge their risks, a new asset class, derivatives, was born in the 1980s.
But over the years a number of substantial losses have served as a reminder that regulation and greater levels of transparency are needed to prevent these instruments from turning toxic.
Centralized clearing and increased reporting requirements are shedding new light on these instruments used for hedging and speculating, but they remain controversial, as highlighted by the recent $2 billion loss at JPMorgan Chase.
The era of swaps and over-the-counter derivatives began in the 1980s, when more corporations and financial institutions sought to hedge interest rate, exchange rate and commodity price risks.
In 1994 a series of large losses were incurred by such global companies as Procter & Gamble and Metallgesellschaft, one of Germany's largest industrial conglomerates.
In 1995 rogue trader Nick Leeson in Singapore lost $1 billion on futures pegged to the Nikkei 225 stock index in Japan, leading to the demise of Barings, the UK's oldest investment bank. Warren Buffett, chairman and CEO of Berkshire Hathaway, warned in 2002: "These instruments will almost certainly multiply in variety and number until some event makes their toxicity clear. These are weapons of mass destruction."
In 2008, American International Group's credit default swaps brought the financial system to the brink of collapse. At its peak, the OTC market had a notional value of $300 trillion in the US alone. Efforts to regulate OTC derivatives are under way in the US and Europe, although deadlines agreed upon by the G20 are unlikely to be met.