Derivatives: The Devil’s Work?

Are derivatives really all bad?

Derivatives have increasingly come under the microscope recently in the fallout from the global financial crisis, and more local trading institutions are falling by the wayside than ever before. With investors wary of underlying value falling far short of the value of the derivatives themselves, these instruments have appear to have fallen out of favour.

The question that bears asking, however, is whether this skittishness is justified, and whether derivatives are really as risky as they appear to be in the current climate.

There is no doubt that the local market has been through turbulent times before, says Tony van Niekerk of Grindrod Bank. In South Africa, three local financial institutions failed on the back of toxic derivatives in the 1990’s; Sechold Bank in 1994, Prima Bank in 1995, and RAD Bank a few years later. All it took was a few traders operating either illegally – or the necessary risk monitoring systems in place - to bring them to their knees. In these early cases clients did not lose any funds, but the effect was felt by other banks when the over the counter options could not be honoured.

More recently, Dealstream became another casualty after passing off CFDs (contracts for difference) as JSE-listed single stock futures. In this case, client losses as a result of the fraud were massive. Similarly, Cortex Securities accumulated a sizeable portion of “some rather illiquid ----–small capitalisation shares”, as Tony van Niekerk puts it, which ended up costing shareholders and the clearing bank, ABSA Bank, concerned a cool R1.4 billion.

Despite these shenanigans the South African derivatives market actually continues to operate like clockwork, and has single-handedly contributed to a massive growth in trading instruments on the JSE. All local clearing banks have avoided the plight of their international counterparts, and have managed to retain both their balance sheets and their dignity.

“We can also thank the government for that tricky little piece of legislation called the National Credit Act,” says van Niekerk, “and, for once, exchange controls have worked in our favour and kept the sub prime at bay. All told, our markets have held together rather well, and our conservative rate cuts have allowed us to weather the storm better than most.”

As importantly, many asset managers and pension funds have continued to obtain great vale from the use of derivatives in their portfolios.

“Any savvy consultant, manager or trustee able to deliver sound asset and liability modelling has used the local derivatives market to replicate risk exposures, reduce unnecessary risk exposures, and provide good countenance in the form of hedging.”

Essentially, derivatives provide the tools to reduce, change, increase and gear exposure in almost every portfolio that has funds invested in the local market.

How these tools are managed is, of course, where the danger lies, and in a marketplace fraught with bad investment advice, it is not the instruments themselves that are “the devil’s work”, but rather those who use them recklessly or dishonestly, especially without respect to JSE regulations. This is why the choice of institution remains such an important one, and why investors should be careful to select one that has a proven track record, is bound by JSE regulations, and is preferably part of an internationally-monitored network.

“Given the current market situation, and the huge deficits faced by large pension funds and investors alike, I can only urge trustees and decision makers not to turn their backs on derivatives,” says van Niekerk. “With sensible asset and liability analysis, and a carefully-considered investment strategy, the use of derivatives can ensure that funds retain their value through the current financial crisis. “In the hands of professionals these remain valuable instruments for any portfolio.”