For some the word “derivative” is synonymous with everything that is wrong with capital markets, trading for trading sake, rampant profiteering, nothing to do with the financial needs of real people. These are a few of the charges ranged against the financial derivative but is that a fair reflection or is there a softer side to this apparently irredeemable beast.
The origins of derivative contracts do indeed begin with meeting the needs of ordinary folks. Farmers in the Mid-west in the mid 1800’s were faced with financial ruin due to severe fluctuations in the price of corn. By the time they had paid for seed corn plus the expense of growing it and harvesting it they faced the probability of having to sell it for a loss. The simple idea of agreeing a fixed price in the future that locked in a guaranteed profit for the farmer was in fact the birth of modern financial markets with the first corn contracts being offered on the Chicago Board of Trade on March 13, 1851. Of course in order to allow the farmers to hedge the price of corn there needed to be someone willing to offer a fixed price in the future – enter the speculator. A simple and obvious fact over-looked by those who wish to denounce market forces is that there can be no hedgers without speculators.
Remarkably, however, more than one hundred years would pass before the concept of a forward hedge would translate from farming needs and commodities trading into the financial markets proper. The International Monetary Market (IMM) offered the world’s first foreign exchange futures contract on 31st December 1974. Once again the emergence of these early derivative contracts arising from a need to stabilize foreign exchange fluctuations as the post world war II international monetary agreement known as Bretton Woods broke down.
As each new layer of abstraction built upon previous layers the world of derivatives trading grew to encompass more and more aspects of the financial markets. For example, futures on interest rates were added to the already existing currency futures and futures on gold with the establishment of futures on U.S. Treasury bills in January 1976.
In the last 30 years the trend has continued with ever increasing complexity. Options on Futures by the early 1980’s, followed by over-the-counter swaps and options in the mid 1980’s and continuing with credit derivatives in the 1990’s and insurance derivatives in the early 2000’s.
What began as a simple means of hedging the price of corn has become a global market that trades trillions of dollars per day. The interactions and correlations between markets that were once considered separate are today closely connected,with price shocks rippling from one market to another. The development of computer systems has been the single most important “enzyme” without which it would simply not have been possible for markets to grow.
Ironically, it is now the inability of computer systems for risk management to keep pace with the markets that is holding back further development. The IT systems landscape within most investment banks is now highly complex with many different systems interacting in ways that are difficult for a human being to understand. Armies of software specialists and consultants maintain fragile systems; “if it ain’t broke don’t fix it” being the mantra of many. But a nest of vipers lies hidden, a tangled web of fragmented and fragile interconnections that means trading firms are vulnerable to substantial losses due to potential system failures. Operational risk within IT systems has the potential to bring about collapse of the entire firm. The time has come for many banks to face up to this problem and tackle it at the grass roots level. Instead of adding more and more patches onto existing systems, radical investment is needed to clean up and bring a structured, well architected systems landscape into being.