DERIVATIVES - financial instruments that are linked to some underlying assets such as commodities or stocks - have been in existence for centuries, used by producers and farmers as a form of risk management. However, only in the last few decades has the use of derivatives extended beyond traditional risk management into the realm of speculation. From around the 1980s onwards, derivatives became, for many institutions, a rich lode of profits. For banks that run proprietary desks trading derivatives, and repackage them to market to retail investors, the instruments are a lucrative source of income and a seemingly clever way to move risk assets off their balance sheets.
But derivatives were at the epicentre of the financial crisis of 2008 when sub-prime mortgages imploded, causing huge losses to institutions such as AIG which - as it turned out - grossly underestimated the instruments' risks. Asian investors were not spared: the failure of Lehman Brothers caused heavy losses in structured products linked to Lehman. Beyond that, not only did liquidity dry up in over-the-counter (OTC) derivative contracts, investors were also stuck in a hard place, forced to deal with their bank as their sole market maker, counterparty and valuer. Since then regulators globally have homed in on derivatives as a potential source of systemic risk that must be reined in through tougher regulation that hopefully raises transparency and liquidity.
The Monetary Authority of Singapore's (MAS) proposal to revamp the way derivative contracts are traded must be seen against the backdrop of the G-20 commitment to reforms in the OTC derivatives market. Its proposal strikes a balance between the need for greater regulatory oversight and the recognition that the market may not be ready for now to fulfil all the requirements as recommended by the Financial Stability Board.
In the latter respect, for instance, while MAS proposes central clearing of OTC contracts and the reporting of trades to regulated trade repositories, it proposes not to require trading on exchanges or electronic platforms - at least for now. The option, however, will be closely studied and may be a matter of time.
For regulators, one challenge is to raise oversight in a way that does not limit the flexibility of end-users to customise contracts for their particular needs. As for end-users who are retail investors, standardised contracts that can be traded on an established exchange are the way to go to mitigate the risk of an extreme scenario akin to 2008. The global derivatives market - the notional value of outstanding contracts exceeded US$700 trillion last year - will continue to grow. Increased regulation may not prevent another crisis. But by shining a light on the complex links in the interlocking chain of a derivatives trade, it is hoped that the contagion effect on a market can be more quickly and effectively contained. That may well be the best outcome.