THE ROLE OF DERIVATIVES

The issue of derivatives is one which has received occasional mention in the mainstream media. Derivatives have also received more widespread attention among certain pundits purporting to know a thing or two about economics; the trouble here, though, is we hear little more than hysterical ravings about how derivatives are about to cause the end of the world. Little in the way of helpful or explanatory information is offered by these types to explain exactly what derivatives are, how they work, and what the benefits (and dangers) are to the economy. Two preliminary things here, more qualified experts openions. First, we can simplify things by defining this important term. The root word of derivative is derive. Derivatives are financial instruments which are derived from some underlying commodity or asset. Most all of you have heard of an option before; this is a financial instrument giving you the option to buy or sell a certain security at a certain price, and by a certain date. Technically, an option itself is a derivative, as it is derived from and dependent on the fate of an underlying asset. So, youll have an easier time in general understanding derivatives as just what they are; sophisticated "bets" on the fate of underlying stocks, bonds, interest rate levels, currencies, commodities and such. The second thing to understand about derivatives is that their use has been critical to the continued life of our fractional reserve banking/credit system, and to the broader economy. It has become necessary for the financial system to create ever more intricate--and inherently risky--devices to "create" wealth. Through the multiplication of these derivative contracts, prices for many of the underlying assets have been artificially increased. This new "wealth" has served as the basis for ever more credit creation, merger deals and other means for keeping the rubber band stretching even more. The trouble is, as even Fed Chairman Alan Greenspan (generally a fan of derivatives) has implied before, the wonderful wealth-creating attributes of derivatives could reverse one day. These very same instruments that have been responsible for the creation of trillions of dollars worth of enhanced values of underlying assets could indeed end up being indiscriminate destroyers of capital, were they to "unwind" in a significant way. This happened with Long Term Capital Management, a hedge fund collapse that nearly brought down the entire system. It happened with Enron; but regulators were on top of things sufficiently ahead of time to limit, for now, the ripple effects. They might not be so lucky next time. For those of you who want to take the time to study the derivative issue further, it is strongly suggested visiting www.econstrat.com, which is the web site for the Derivatives Study Center. In scouring the Web myself for the most understandable explanations to pass along to you, the commentaries and "primer" by the Centers Randall Dodd truly stood out. In his "Derivatives Primer," Dodd--after discussing how these kinds of contracts in a broad sense arent exactly new--discusses the risks inherent in derivatives: "The first danger posed by derivatives comes from the leverage they provide to both hedgers and speculators," he writes. "Derivatives allow investors to take a large price position in the market while committing only a small amount of capital--thus the use of their capital is leveraged. . ." Back to the Long Term Capital story: some of you remember that this hedge fund had raised approximately $3 billion from investors. Yet, when LTCM blew up, it had "notional" (presumed face) value of derivatives of an astounding $1.4 trillion. This happened because LTCM milked derivative contracts ability to create artificial wealth for all they were worth. In the process--and this is one of the inflationary components of what derivatives do--the placing/creating of all these fancy "bets" skewed the values of underlying assets considerably.

Many of you know that if all of a sudden there is unusually large activity, lets say, in the options for XYZ Company, the share price of that same company will be affected. If a number of options are suddenly being either created or bought betting that XYZ is going up, then the share price of the stock itself will usually go up, as investors think that "somebody knows something good is going to happen." Yet, this might not really be true; and it could be nothing more than the (at its core) unnatural effect of these kinds of derivative activity that give XYZ a falsely inflated value, and give investors similarly wrong expectations. Using the LTCM example above, you can imagine the magnitude even now of still-inflated values in the financial markets courtesy of derivatives. In his Primer, Dodd also bemoans the fact that further risks are presented due to the fact that many derivatives traded Over the Counter are mysterious. They are not regulated, nor is there much information available as to their quantity and character. Recently, Sen. Dianne Feinstein (D-CA) attempted to get legislation acted upon which would regulate these, the very same types of deals, it should be remembered, were engaged in by Enron. However, everyone from Fed Chairman Greenspan to Wall Street turned on the lobbying offensive, and her move was defeated. Thus, even after all the hand-wringing over Enron, it appears that the majority of legislators are perfectly willing to allow this ticking time bomb to exist. Finishing up the commentary section of his primer, Dodd states, "In sum, the enormous derivatives markets are both useful and dangerous. Current methods of regulating these markets are not adequate to assure that the markets are safe and sound and that disruptions from these markets do not spill over into the broad economy." No doubt this is an understatement; and the fact that Alan Greenspan, for his part, is unwilling to see this huge inflationary mechanism regulated--in spite of the risks--underscores just how unable he is without derivatives to keep the overall credit bubble and the dollar from deflating much further.

The Role of Derivatives Markets

Futures and options markets are derivative markets (though certainly not the only types of derivative products), which means that they exist in relation to spot markets, which are the underlying primary markets in which actual physical commodities are bought and sold. Because futures and options contracts allow for the delivery of the underlying commodity upon expiration, there is a strong tendency for spot, futures and option prices to move in the same direction and react to the same economic factors.

Where do they develop?

Derivatives markets tend to develop in large, competitive spot markets that have volatile prices. In the case of the EU ETS however, the forward and futures markets have developed faster than the spot market. Approximately 95% of the total volume in the European carbon market is seen in derivative trades (forwards, futures and options) with the remaining in spot trades. This can partly be explained by the initial delay of national registries and final allocations in many of the EU Member States which prevented the execution of instant delivery for spot contracts. Another reason may be that in such a new and volatile market, derivative instruments are crucial tools to optimise the value of your emissions portfolio.

What does trading derivatives involve?

Derivatives involve the trading of obligations (futures) and rights (options) based on an underlying product, without necessarily directly transferring that underlying product. The most familiar derivative instruments are exchange-traded futures and options based on an underlying product. On the European Climate Exchange, the underlying unit of trading are the EU allowances (EUAs) which are granted to companies under the EU Emissions Trading Scheme (EU ETS).

ECX Derivatives
The ECX CFI Futures and Options Contracts provide an example of standardised terms of trade. The standardized nature of futures and options markets makes them inexpensive and reliable to use for those with a commercial interest in the EU ETS. Because futures and options contracts attract industrials, utilities and financials of various nature, futures and options of a commodity often develop into a deep and liquid market. Market depth and liquidity means trades can be executed quickly without displacing prices. In sum, derivatives are traded either on exchanges (where trading is public, multilateral and closely regulated by governments and the exchanges themselves), or between two or more parties in over-the-counter markets (where trading is non-public and largely outside government regulation).

Two-fold Role of Derivatives

Derivative markets have two central roles: risk transfer and price discovery. For market participants, the primary purposes of derivatives markets are:

To transfer the risk of adverse changes in commodity prices from those who wish to reduce risk to those willing to accept it. Commercial firms (that produce or use the commodity) shift part of the risk of price change to proprietary traders, who willingly assume that risk for the opportunity to earn a profit on their venture capital. The revelation of price information that reflects a multitude of market opinions. These are the views of the various traders involved in the markets. Because futures and option markets funnel large quantities of bids and offers that result in publicly disseminated transaction prices, futures and options markets often become the primary source of price discovery for the related commodities.

Derivatives and the EU ETS

Derivative markets play an important role in the EU ETS. By allowing market participants to reduce exposure to price risk, buyers and sellers can better plan their businesses. By revealing the markets summary of the value of the underlying product, derivative markets inform those with a major stake in those commodities and financial instruments. The availability of these markets has provided the means to allow greater risk to be absorbed, thus facilitating growth and efficiency in each of the associated industries. Market users have improved predictability of future business conditions, which allows for expansion of lending and commodity production and facilitates borrowing for business growth. These results can lead to reductions in prices and interest rates paid by consumers.