The Next Episode: Derivatives in the Information Age

In last week’s blog post we explored the origins of derivatives, as far back as 4000 BCE. In this follow up, we explore the impact of technology, deregulation and globalisation on financial markets.

The 1970s heralded unprecedented change, transforming derivatives trading and reshaping markets. Technology and policy combined to create a febrile environment for financial innovation.

In the aftermath of the collapse of the Bretton Woods system of fixed exchange rates, governments deregulated price controls in markets. Financial institutions, corporates and public sector clients lacked the tools to manage price volatility and hedge risk. The dawn of the Computer Age changed everything. Now counterparties possessed computational tools powerful enough to run complex pricing models.

In 1973, Fischer Black and Myron Scholes published their seminal paper on options pricing, imaginatively entitled, “The Pricing of Options and Corporate Liabilities”. The same year, the Chicago Board of Trade opened the Chicago Board Options Exchange.

The adoption of a target for money growth by the US Federal Reserve as its monetary policy instrument lead to increased interest rate volatility in Treasury bonds. This raised demand for interest rate derivatives to hedge against adverse rates movements.

Furthermore, the dominance of a few large commodity producers was broken. Price discovery better reflected global supply and demand dynamics but the ensuing volatility in the spot market created demand for derivatives to help traders hedge prices. It was during the 1970s that crude oil forwards contracts became popular in response to the machinations of OPEC.

With a consensus pricing methodology, microprocessors to handle the maths, a market to trade and clear demand, the building blocks were in place. The derivatives market exploded. Older organized exchanges like the CME, CBOT and CBOE expanded from handling commodity options and futures into new kinds of contracts, including currency, debt and index derivatives.

And there was also a huge rise in Over The Counter (OTC) transactions as sophisticated clients looked for bespoke risk management solutions. Whereas in 1986 the total value of outstanding exchange-traded derivatives contracts was larger than that for OTC, by 2008 OTC activity was worth roughly ten times as much, despite the fact that the exchange-traded derivatives market had increased in value 100-fold over this period. The total annual notional value of OTC derivatives is now hundreds of trillions of dollars.

The OTC market gave rise to a new financial instrument – swaps. The first swap transaction was executed in 1981, when Salomon Brothers arranged a currency swap between IBM and the World Bank. Soon interest rate and commodity swaps joined the party.

The 1980s also saw derivatives trading spread geographically, with futures markets opening in London (LIFFE) and France (MATIF), as well as Tokyo, Osaka, Singapore and Hong Kong.

Next came electronic trading. Pioneered by the The Chicago Mercantile Exchange in 1992, screen trading has achieved ubiquity by providing more liquidity, efficiency and transparency to derivatives markets. Later, the emerging market financial crises of the 1990s increased demand for instruments to hedge against credit risk. After 1995, credit default swaps entered the mainstream.

The macro backdrop played a role, too. Globalisation and increased trade between countries led to an exponential rise in derivatives trading, with enormous demand for protection against exchange rate movements via instruments such as forward exchange contracts and cross-currency swaps. The trend towards deregulation accelerated this move – particularly the 1999 repeal of Glass-Steagal.

In the mid 2000s, property derivatives entered the mainstream as advances in financial engineering increased the range of solutions available to investors. A lack of understanding regarding the way these products were structured came back to haunt policy-makers during the crisis of 2007/8.

Derivatives have been blamed for several high-profile events that have rocked financial markets since the 1990s, including the fall of Barings Bank in 1995, Long Term Capital Management in 1998 and Enron in 2001. And who can forget the collapse of Lehman Brothers and AIG in 2008?

Illiquid OTC derivatives do make price discovery more difficult and can contribute to market panic and systemic risk. But derivatives are only as dangerous as the people who trade them. If handled responsibly, they bring significant economic benefits on a macro level, helping financial institutions, corporates and public sector entities manage market and credit risk, increasing market resilience to shocks. Indeed, surveys suggest that 64% of US companies use derivatives to hedge interest rate and currency risks. That means a more productive global economy and better living standards for all. Just as the Sumerians and Ancient Greeks used derivatives to fund trade, exploration and advancement, so do we.

The story of derivatives shows how exogenous forces combine to drive markets forward in unexpected ways. Six thousand years of politics, economics, technology and culture have shaped the world we work in today. These forces will shape our future, too.