Derivatives: Smoking guns or untapped tools? - Scott Appleton

Derivatives have had a bad press in recent years but they remain popular financial instruments.

Derivatives may have been famously labelled ‘financial weapons of mass destruction’ by legendary US investor Warren Buffett, and regarded by some as a root cause of the global financial crisis, but investors’ continued enthusiasm for them contradicts simple, negative headlines, say experts.

Derivative instruments continue to play a significant role in the financial planning of many of the world’s largest companies, and may even present new, untapped tools for non-traditional business sectors, believe some.

‘Rather unfairly as products go, derivatives have been put on the defensive of late. The industry probably needs, like America’s National Rifle Association, a catchy answer. Something like: “derivatives don’t destroy businesses, people do”’, says Jeffrey Golden, London-based founder partner of Allen & Overy’s US law group and senior partner in the firm’s derivatives practice.

The perception that there is a fundamental ‘problem’ with derivatives fails to acknowledge the depth of the transactional markets and the very many different financial instruments that fall under the ‘derivatives’ label, say others.

‘Even in the face of events over the past year there nonetheless remains considerable investor interest and support for equity, interest and currency swap derivatives, which remain intrinsically linked to many businesses’ day-to-day financing needs’, says Jonathan Ross, partner at Bell Gully in Auckland and Senior Vice-Chair of the IBA’s Securities Law Committee.

‘Different types of users – banks, finance and corporate entities – continue to use derivatives to help manage ongoing commercial risks, while other entities – hedge, pension and private equity funds – continue to use them speculatively as well as for investment purposes. The balance between the two sides is, however, essential to ensure market liquidity.’

Speculative

Clearly issues have arisen around the speculative use of derivative products and the subsequent liabilities some companies have faced as transactions have gone ‘bad’, as well as the ability of some to capitalise on the misfortunes of publicly listed companies through short-selling.

‘Derivatives continue to make sense in the right situation but people have to fully understand what they are taking on. In the past, some have clearly used derivative products in the belief that the markets would only go one way – up’, says Pere Kirchner, corporate partner at Cuatrecasas Gonçalves Pereira in Madrid, and Co-Chair of the IBA’s Securities Law Committee.

The collapse of Barings Bank in 1995 was largely the result of unauthorised and illjudged trading by its head derivatives trader in Singapore, Nick Leeson. More recently, December 2008 saw US insurance giant American International Group (AIG) pay an estimated US$18.7 billion to close obligations surrounding credit default swap derivative transactions (CDS) – where one party insures another against the loss in value of an asset – while January 2009 saw Société Générale lose US$7.2 billion through futures contracts.

‘Simply “following the herd” is not a good thing. Knowledge of the products as well as a market participant’s appetite for and competence to manage its risk are key issues. Derivatives present a still unrivalled way for business to hedge against events they can’t control but as a speculative tool they clearly offer risks as well as rewards’, cautions Golden.

‘I shudder to think what the regulators would now be looking to remedy if market initiatives to settle CDS credit events had been less successful’

Jeffrey Golden
Allen & Overy

Regulation

The capacity for such spectacular losses and the potential negative financial impact derivatives trades can have on companies’ bottom lines have inevitably prompted some to call for greater regulation of derivatives transactions.

In May, President Barack Obama unveiled US plans to regulate private ‘over-the-counter’ (OTC) derivatives contracts more closely. Supported by the US Federal Reserve, Treasury and Securities and Exchange Commission (SEC), the proposals include the mandatory clearing and exchange-trading of standardised products, with parties required to report trades, hold a minimum level of capital to cover losses and promote greater price transparency and risk awareness.

‘A key issue is clearly the role that established market disciplines play, but there has also emerged a desire to balance the right for private parties to enter into contractual negotiations with public regulatory needs’, says Ross. ‘The real recurring issue, however, is the ability of parties to fully understand exactly what it is that is being traded and the risks they enter into – and fundamentally what happens if the underlying asset loses its value.’ Lawyers accept that more efforts may be required to educate derivatives traders about transactional risk, but some nonetheless question the usefulness or need to move private derivatives transactions onto exchange platforms.

‘The legal infrastructure for the OTC derivatives market is robust. Derivatives contracts have been enforced in accordance with their terms, and, with hundreds of lawyers contributing over many years now, much has been done to improve documentation and legal certainty for such trading’, says Golden.

Parties already use well-regulated future exchanges and utilise pre-formed products that may more or less cover most needs, but predominantly the focus there is towards relatively simple future or swap products, notes Pedro Cardigos, a specialist finance and derivatives practitioner at Lisbon-based firm Cardigos.

‘Standardised products often mean fixed deal amounts and time periods and pre-defined terms that may not always suit individual requirements; parties may find themselves having to hedge against an index rather than an individual share, and if you have an illiquid product then forget it: the only option is a private OTC derivatives contract.’

Clearly there will, however, be continuing fallout from the recent misuse or ill-judged use of derivatives products, which may present lawyers and national courts with emerging issues.

‘A question we should be asking is: what role would we wish the courts to play in the resolution of derivatives disputes and complex product litigation and are the courts ready to play that role? How can we as lawyers help them to better understand the issues, should we be doing more and also what role, for example, can a professional body like the IBA play in this?’, asks Golden.

Robustness

Specialist lawyers continue, however, to emphasise the collective engagement of lawyers to ensure the ‘robustness’ of OTC derivatives contracts being entered into. In any event, entities continue to rely on currency or interest rate swaps and futures contracts to help mitigate commercial risks beyond their control.

‘I shudder to think what the regulators or politicians would now be looking to remedy if industry documentation and terms of outstanding trades had not been honoured and market initiatives to settle CDS credit events had been less successful’, says Golden.

Research published in spring 2009 by the International Swaps and Derivatives Association (ISDA) – one of the world’s largest global financial trade associations, which represents parties in privately negotiated OTC derivatives transactions – revealed that 94 per cent of the world’s 500 largest companies continue to use derivative instruments to manage and hedge business and financial risks. The survey found that foreign exchange derivatives are the most widely used (88 per cent of the sample), followed by interest rate derivatives (83 per cent) and commodity derivatives.

‘We would not have seen such growth and diversification in the derivatives market if there wasn’t a benefit being provided to users of these products’, adds Golden.

Cardigos agrees – he has been busier with derivatives issues over the past 12 months than at any time previously, he says. ‘We have seen stock market crashes and interest rates at historical lows, situations that no one could have predicted but which are prompting companies to place even more emphasis on managing their business risks; and clearly there remains the appetite among speculative institutions to keep buying new derivative risks.’

Non-traditional

Others emphasise that derivatives are beginning to emerge as a financial resource in previously untested business sectors. Golden, for example, highlights the role currency swap transactions are playing in the microfinance sector.

He is currently working with Washington DC-based MFX Solutions, he says, which aims to help microfinance institutions manage currency fluctuations – an issue frequently faced as fundraising is often carried out in hard currencies that are different to those local currencies in which the loans are made or repaid.

‘Microfinance means making small – often life-changing – loans to people to help empower them economically. The default rate is often much lower than traditional lending but the business model of many microfinance institutions has been challenged by the strong currency fluctuations of the past year.’

From a derivatives standpoint, remedying such vagaries is not a complicated issue, he says. ‘Swaps and forwards contracts can help microfinance lenders control their risk, grow responsibly and continue their good work.’

Future markets

Lawyers remain confident therefore that demand continues for derivatives contracts, of all types, and that fundamentally the established documentation that underpins most OTC transactions retains the requisite certainty and enforceability. The ISDA’s template master agreements, for example, are estimated to support transactions worth up to US$500 trillion with only a fraction related to CDS contracts.

‘The belief remains that the sector’s master agreements remain solid, albeit highly technical. Derivatives is clearly the domain of specialists but by and large it has not been the documentation in these contracts that has been left “wanting”’, says Ross.

Kirchner notes that the same standard documentation is often relied on even outside the Anglo-Saxon markets. ‘The derivatives documentation used in Spain is the same as that used in English markets; they are often not even translated. The counterparty is often in any event an Anglo-Saxon entity and the types of businesses using these products highly sophisticated.’

Lawyers note that the most relevant derivatives trade bodies and exchanges have increased programmes to ensure adherence to accepted codes of practice, with the ISDA notably establishing its ‘big bang protocol’, specifying standard auction settlement procedures and related terms applicable to credit default swap transactions, to which there are now almost 2,000 signatories – banks, financial institutions and companies.

Derivatives are here to stay despite the dramatic negative headlines, say lawyers. The ability of companies to manage future interest, currency or commodity fluctuations is simply too important to their financial well-being, while speculation is essential for the efficient functioning of the markets.

Says Golden: ‘The majority of derivatives transactions remain relatively simple and easy to understand. Derivatives will continue to enable companies to shift risks from where they naturally fall to those who can best manage them. Parties will remain understandably keen to forego some of the upside potential of their position in order to hedge against a rising cost or falling price or value that might be their worst nightmare.’

For many companies, the use of derivatives remains basic business common sense.

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Scott Appleton is an Editor at Iberian Lawyer based in Madrid. He can be contacted by e-mail at scott.appleton@iberianlegalgroup.com.