The danger of derivatives
Warren Buffett’s comment that financial derivatives are ‘time bombs’ that have the potential to destroy the financial system attracted a lot of interest when it was published last month.
In one sense, this is nothing new. There is a list of banks and corporations that have been hit as a result of misfortune or misconduct in the derivatives markets. It is inevitable there will be future losses from derivatives – what is uncertain is which institution will be hit and to what degree.
At the same time, these comments do remind us of some very real concerns that derivatives raise for corporate treasurers.
Many treasurers use derivatives as protection, not speculation, as a means of hedging hedge exposures, particularly to interest rate and currency risk. Treasurers need to understand the relationship between the exposure and the derivative used to hedge it, and the nature of the derivative instrument itself. The use of derivatives should not give rise to additional exposures.
Buffett argues that banks do not fully understand the nature of their exposure to credit derivatives and this poses a threat to the international financial system. This concern needs more attention.
Corporate treasurers cannot measure the risk that credit derivatives pose to banks. However, the concern over credit derivatives reminds us of the need to manage bank counterparty risk. Furthermore, it underlines the point that an individual bank does not have a right to exist. There is a chance, however small, that a bank will fail, as others have failed before.
Some treasurers will take this as an opportunity to revisit their exposure to bank counterparty risk. Whether credit derivatives will trigger a banking collapse remains to be seen. However, we do know that another bank will fail at some point in the future. It is this risk that should be minimised.