A Greek Tragedy

A Greek Tragedy

Finance markets defend derivative contracts by pointing to their long history. One of the oldest recorded references to a derivative contract appears in ancient Greek literature. In Chapter 9 of Aristotle’s Politics, a philosopher gains a handsome profit by agreeing to place a deposit on olive presses one year in advance of the next olive harvest. In securing rights to the presses prior to the harvest, the buyer, Thalus ensures that if the harvest is bountiful, he will have access to the presses at the lower negotiated rate that press operators are grateful to receive in advance of the harvest.

Investigations reveal that derivatives played a critical role in Greece’s recent credit woes, threatening to collapse the country’s economy and de-stabilize neighbors. (See here.) Financial markets use the term derivative to describe a transaction that derives its value from an independent reference asset. Finance literature identifies four basic types of derivatives contracts –futures,  forwards, options  and swaps. Futures and forwards involve agreements to deliver goods at a stated contract price on a specified future date. Thalus’s right (assuming he has no obligation to exercise the right but may suffer the loss of the deposit if he does not exercise the right) to elect to access the olive presses at a price negotiated in advance, illustrates features of a classic option contract. Swap agreements allow counterparties to exchange a series of cash flows over time. The market classifies derivatives based on the reference asset used to determine the value of the agreement. For example, we refer to a swap agreement for which the reference asset is an agricultural product (corn, soybeans, cotton, grain) or a raw material (copper, crude oil, natural gas) as a commodity swap. The reference asset for a financial swap likely involves one of the following: foreign currencies, bonds, stocks, and other financial assets and liabilities. Thus, the jargon evolves and we have foreign currency swaps, interest rate swaps and equity swaps among the many varietals.

While commodity derivatives may date back to Mesopotamia (see here), the Dojima rice futures exchange in shogunate Japan (see here), or the tulip bubble in Holland, financial derivatives are the product of financial innovation. In the 1980’s, derivatives traders at Salomon Brothers engineered a foreign currency swap.  The transaction allowed the World Bank and IBM to swap risk exposure to foreign currency exchange rates; the two entities exchanged bond payment obligations and bond earnings denominated in Swiss Francs and German Deutsche marks, respectively, in a $210 million transaction.  Parties using derivatives attempt to limit their exposure to or predict future movements in the price of the reference asset.

Futures and options trade on registered exchanges. Other derivatives are privately negotiated, bi-lateral agreements that trade over-the-counter among dealers and financial intermediaries. There is often little or no record of the parties originating the instruments. The ability to originate and trade these instruments in the shadows may have motivated some actors to make bad bets.

Greece’s concerns stem from the use of interest-rate and foreign currency swaps. These instruments serve useful and important functions in allowing parties to manage their exposure to volatile interest rate and foreign currency markets. The complexity of pricing the instruments and the opacity of the market, however, engendered grave concerns. According to reports, Greece used derivative transactions that involved securitized rights to cash flows from national projects to conceal mounting debt. Greece’s current troubles exemplify the need for greater transparency and accountability in derivative markets.

The Greek debacle with swaps illuminates the need to address oversight of derivatives from a global perspective. The markets for derivatives involve financial services firms that may be domiciled in the United States or Europe but whose influence and relationships are undeniably international. The financial instability of systemically significant private institutions (investment banks or international insurance firms or sovereign debtors) threatens global market disruptions. We are left pondering the effectiveness of any domestic derivative market reform that lacks international collaboration. (See here.)

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7 Responses

  1. A.J. Sutter says:

    What precisely is the distinction you’re making when you say “While commodity derivatives may date back to Mesopotamia … financial derivatives are the product of financial innovation”? What should we call what they did in Mesopotamia? What’s added by calling any sort of instrument “financial innovation”? Does that mean derivatives are somehow worse? or that, as “innovation,” they deserve more respect? The contemporary fetishization of “innovation” masks the fact that much of our society is based on ideas and inventions that have been around for quite a long time. How does the category of “financial innovation” illuminate any pertinent issue here?

    Also, your point about the necessity of international collaboration isn’t necessarily well-illustrated by this case. The entity that used the derivatives was a sovereign government. It seems hard to claim that they didn’t know what they were doing with the derivatives. The motivation for the use of the instruments was the constraint of a common currency, which is pretty rare in the world. A more salient problem in this case is the lack of regulation within the EU, rather than regulation of Goldman or other banks, or cooperation with the US. If the Eurozone member states were to revert to national currencies, it seems as if there should be less occasion for this particular problem to come up (at least, as distinct from a country’s treasury possibly using derivatives for pure financial speculation, à la California’s Orange County in the early 1990s).

    BTW, the Goldman-Greece-derivatives story was broken by Germany’s Der Spiegel on 02/02, almost 2 weeks before it hit the NYT. It was also common knowledge in financial circles here in Japan within a day or two after the German report. But before the story broke in a major Anglophone news outlet, Goldman had cut Greek and Italian banks to ‘sell’ and lowered its public euro-vs-dollar forecast because of “Greece turmoil.” Maybe a first step to regulating derivatives markets would be a moratorium on Goldmanites in the US government (retroactive, please), so that the firm’s life might be a bit less charmed. To say nothing of regulators’ learning to read news reports in foreign languages.

  2. A.J. Sutter says:

    [Correction: The Spiegel story was 2010/02/06, still more than a week before major English-speaking media gave it prominent space.]

  3. Frank Pasquale says:

    Thank you for an illuminating commentary on the problems here.

    I completely agree on the need for international cooperation. I’ve been reading DeLong and Cohen’s The End of Influence, and it reinforces my impression that capital is mobile enough to evade many domestic strictures. But given the lack of effective international regulators, we’re forced to hope that some states at the hub of the neoliberal order “set the tone” in matters like this. I just hope that Gary Gensler manages to educate enough congressmen to back his version of derivatives regulation. See
    http://www.businessweek.com/magazine/content/10_08/b4167068042271.htm?chan=magazine+channel_what%27s+next

    (And given the article title “A Goldman Guy Turns on the Street,” we may well be in a “Nixon goes to China” moment here, A.J.!)

  4. Mike Zimmer says:

    I understand that there can be economic value to derivatives that do involve actual hedging of risks of various types. What I don’t understand is why deriviatives that are unconnected to any economic actiity that justifies hedging are anything other than gambling contracts. As such, shouldn’t they be as illegal as my betting on the outcome of the NCAA’s March Madness?

  5. Kristin Johnson says:

    A.J.,
    Thank you for your thoughtful comment. If there is anything new under the sun with respect to the derivatives that are at issue it centers on the investment instruments that are the subject matter of the agreements. I believe that we agree that historic examples of each of the four classes of derivatives disproves arguments that derivatives are nascent creatures. Unlike the many historic examples, however, the harsh spotlight in domestic and international press has focused upon derivatives for which the reference asset is a financial product such as a stock or bond, an equity or debt index, or interest or currency exchange rate. Instruments like naked credit default swaps which may settle for cash permit a counterparty to enter into a derivative arrangement without any expectation of physical delivery of the reference asset at settlement (largely because the protection buyer does not actually own the reference asset).

    I agree that the Grecian example is not perfectly matched with the argument. I actually make the argument in a longer paper in the context of competition among international regulators and a possible race to the bottom if there is not international collaboration. The point about the ubiquitousness of the significant market participants, and my experience as a former employee for two of the largest of those players, suggests that like hedge-fund and private equity fund capital, if lesser regulation exists in any jurisdiction, operations will find their way to the same location – tiny island or hot, dry dessert! Greece’s struggles are a more useful example of the interconnected of nations’ economies and the extent to which there is, if you will, a “international moral hazard” for countries within the Eurozone.

  6. Kristin Johnson says:

    Frank,

    Thank you so much for your comments. Following on from my comments to AJ and concurring with your reflections, capital is unbounded by the imagined (?) jurisdictional boundaries that stymie regulators efforts’ to address uniformly disconcerting industry practices or systemic risk engendering products. I just had a call with a friend who works with hedge funds who suggested- much to my surprise – that the industry expects for many of the most significant reforms proposed to fall by the wayside due to lack of political will for adoption of the same. I am familiar with Gensler’s position and due to his tenacious efforts and his comprehensive understanding of these instruments, I believed that there was a movement afoot to ensure adoption of key proposals such as imposition of clearinghouse platforms for OTC derivatives. It looks like the movement has waned and maybe the most critical elements of the initially proposed reforms will not find their way into adopted reforms. That would be unfortunate.

  7. A.J. Sutter says:

    Frank, some of us of a certain age recall that Nixon was still Nixon when he returned from China. E.g., his burglary years were ahead of him at that point. Is a Charles Colson, born-again analogy more suitable? Minus a prison stint, will it be durable?