Why Bank Derivative Trades Aren’t So Risky

Warren Buffett called derivatives “financial weapons of mass destruction”
Lacy O'Toole | CNBC
Warren Buffett called derivatives “financial weapons of mass destruction”

Warren Buffett famously referred to derivatives as "financial weapons of mass destruction," but unless we accept that residential mortgages are too - because enough banks have gone bust or near-bust dealing in those seemingly harmless beasts – the phrase glorifies derivatives into something they are not.

In fact, far from being some sort of exotic doom vehicle, banks need to start looking at derivatives as simply another form of cash instrument, and treat their cash flows accordingly.

We should ban the expression "off-balance sheet" from our personal lexicon, because the cash flows associated with all derivatives, whether contractual cash flows or collateral requirement cash flows, are all very much on the balance sheet.

In the inter-bank market, derivatives are all "collateralized," which means that either party to a bilateral over-the-counter derivative must supply collateral to the counterparty, to the market value of the derivative instrument. The party that is negative "mark-to-market" must supply collateral, in the form of cash or AAA-rated securities, to the party that is positive mark-to-market. This eliminates the credit associated with the instrument, should either party to the contract go bankrupt.

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This makes derivatives dealt between banks reasonably safe to transact from a credit risk point of view. Of course, the market risk is still there (the risk of loss to either party should the instrument go down in value) but that's no different to buying Facebook shares on the day they were issued or being on the wrong side of an FX trade in GBPUSD.

But at least inter-bank derivative trades are more or less immune to credit risk. The first lesson on why derivatives are like cash: one must treat their collateral requirement as a long-term funding requirement, just as one does the funding requirement in making a 10-year loan to a corporate customer.

There is another issue that is exercising the derivatives market right now, and forgive me, it's a rather technical and arcane one. But it's worth being aware of.

When derivatives first came about they were valued under the Black-Scholes-Merton concept of "risk-neutral" pricing and the associated "law of one price". The discount rate in this methodology is in theory the "risk-free" or Treasury bill rate, which banks usually used Libor as a proxy for. But that is actually a bit odd if one thinks about it. If I asked five banks to quote me on a 10-year corporate loan, I would expect to receive five different interest rates, and not be surprised about it. But somehow if I do the same for a 10-year interest-rate swap, I must expect the same value from all of the banks.

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This is a nonsense in the post-crash world when banks (a) no longer borrow money in the wholesale markets at a rate of Libor-flat and (b) all borrow at different rates to each other. So the way the industry is treating this is to apply a "funding value adjustment" (FVA) to the discount rate used to value the derivative, which is essentially a function of the specific bank's funding rate.

That's lesson number two on why derivatives are like cash: because they generate a funding requirement for a bank whenever they are transacted, they need to be valued at the bank's funding rate. Just as one does when valuing a 10-year loan to a corporate.

Some academics and practitioners are up in arms about this, saying that FVA breaks the law of one price and is not logically tenable. The arguments against get even more arcane than what we have discussed here already, so we won't go into them. But in any case, they miss the point.

Banks are in the business of borrowing money to lend money. A derivative transaction generates a borrowing requirement or a lending requirement for a bank, no different from a transaction in the cash market. One would expect to value (discount) this funding requirement at the bank's funding rate in the cash market, so why should it be any different in the derivatives market?

The FVA debate highlights that, far from being weapons of mass destruction, if one views derivative cash flows exactly as one views cash instrument cash flows, our understanding of them - and ability to risk manage them properly - would be much improved.

Derivatives and cash are two sides of the same coin and we should start regarding them as such and risk-manage them as such. One less thing obfuscate and misunderstand when it comes to making the financial markets industry safer.

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Professor Moorad Choudhry is at the Department of Mathematical Sciences, Brunel University and author of The Principles of Banking (John Wiley & Sons 2012)