Crisis will strengthen the role of derivatives

The global derivatives markets have come under sustained assault since the credit crunch began two years ago. As well as being subjected to withering criticism, with many commentators (rightly in my view) blaming some of the more exotic derivatives for contributing to the financial crisis, the derivatives markets themselves have shrunk rapidly in some sectors.

This double whammy has led to a serious reexamination of the entire industry, now being conducted by participants and regulators. I believe the industry will emerge from this process reinvigorated and better able to perform its primary function - the management of risk for the good of investors.

The Middle East, where derivatives markets are in their infancy in many sectors, will benefit enormously from the improvements that will emerge.

Though the creation of individual derivatives can involve complex math, the concept behind them is simple. They are contracts whose value is derived from a range of common underlying entities, including currencies, interest rates, shares, bonds and loans. The growth of the industry globally since 2000 has been phenomenal.

From $100 trillion (Dh367 trillion) worth of outstanding contracts in 2000, it grew to nearly $600 trillion late last year, according to the Bank of International Settlements (BIS).

About 20 per cent of derivatives contracts are traded on an exchange, while the other 80 per cent are traded 'over the counter', known as OTC, meaning they are bought and sold by banks and other parties dealing directly with each other.

As the economic crisis unfolded, positions in OTC equity derivatives shrank by 36 per cent in the second half of 2008 compared to the previous year, while positions in OTC bond and loan derivatives, called credit default swaps, were down by 27 per cent, according to BIS. Credit default swaps in particular have been widely blamed for contributing to the global financial crisis.

Banks have been accused of creating, selling and investing in them without understanding them properly, with the result that far from reducing financial risk, as they were supposed to do, they increased it.

In the United States and Europe, regulators and many market participants are calling for better oversight of OTC derivatives. Their plans include a structural shift away from OTC trading and towards bringing more derivatives activity on to exchanges, to ensure trading takes place in a transparent and regulated environment.

They also want more trades to be cleared by a central counterparty, whether this is an exchange or some other institution, to provide a guarantee that obligations will be met.

These calls for reform are being made with a sense of urgency, because there is widespread agreement that derivatives are an excellent mechanism both for making new investments and for hedging existing ones.

It is vital for investors to have confidence in derivatives as the financial markets inevitably rebound from the crisis and resume their growth.

Share indices provide a good example of how useful derivatives can be. Futures and options based on the world's major indices, such as the S&P 500 in the US and the Hang Seng index in Hong Kong, are widely traded largely because they are an easy-to-use proxy for their constituent shares.

Equity derivatives trading is also increasingly popular in emerging markets. Turnover on the National Stock Exchange in India reached $3 trillion in 2008, with more than 60 per cent taking place in index products and the rest in futures and options based on single stocks.

In the Middle East, investors can trade on-exchange futures listed over the FTSE NASDAQ Dubai UAE 20 index, which correlates closely with markets in the UAE and the wider MENA region.

In a survey published last month by Financial News, European fund managers said their main reason for trading derivatives was to hedge risk. Liability-driven trading (eg swaps) was in second place and cash management (e.g. buying futures) was third. They also revealed that their use of derivatives traded on-exchange has been rising relative to their use of OTC trades.

These trends are positive signals for the future of the derivatives industry. The self-examination that has been prompted by the financial crisis will lead to healthier and better run markets in years to come.

The writer is Chief Executive, NASDAQ Dubai and the views expressed here are his own.