Derivatives are financial instruments whose value depends on something else – a foreign currency, an interest rate, or the anticipated price of an asset at a future date.
For example, a company developing a CDM project may agree to sell 10,000 carbon credits at a price of US$100,000 in five years time. Under such an arrangement, it is able to secure an income in advance of credits being issued, and often before the project has even been approved or implemented. The seller bets that they will be able to deliver the credits (sometimes taking out insurance in case this does not happen) and gains some security against a collapse in prices. By securing future revenues, the seller may also be in a better position to borrow some of the money needed to finance the project in the first place.
The buyer, on the other hand, is betting that the price of credits will rise higher than the figure they initially paid, making this forward trade a good value option. But they are also taking on a financial risk that they may be locked into paying over the odds if prices fall. In practice, that is exactly what has happened with CDM credits, as a result of which such deals have become unpopular. Buyers are instead seeking out options, which (as the name implies) give buyers the right to first refusal on a future purchase, while allowing them to walk away without penalties if the price isn’t right.
Derivatives are either traded on exchanges or over-the-counter. Whereas an exchange is a regulated and organized trading venue, over-the-counter trading takes place away from the gaze of regulators. Such deals are conducted directly between two parties. The majority of derivatives are traded this way.
Derivatives are often described as risk management tools. In the simplest type of forward trade, a producer secures a future price that reduces the risk that they are taking in bringing a product to market – e.g. a farmer is able to set the price they will get for their wheat when planting it. This is a form of hedging.
In reality, most derivatives do not take such a simple form, and the majority of those trading in them are seeking returns from speculation rather than price stability. Derivatives traders make money from arbitrage, which means they are perpetually searching for unstable prices (without which, they would not make any profit). This constantly moving speculation over-rides and undermines the ‘price stabilization’ effect of derivatives, increasing rather than reducing risk. The essence of derivatives trading today is that bets are placed on the value of assets that the parties to the trade do not own and that do not yet even exist. In describing the threat that this poses to the whole financial system, billionaire investor Warren Buffett famously described derivatives as ‘financial weapons of mass destruction.’
The key shift occurred in the late 1970s. Until that time, derivatives trading was considered a form of gambling in the USA unless (as in the case of futures and forwards) the contract could be settled by physical delivery of the underlying commodity – in the above example, a truck of wheat. Alongside the loosening of these restrictions, a market in swaps started to be traded over-the-counter. Since that time, the notional value of the derivatives market grew from nearly nothing to US $ 647 trillion in 2011. Four US banks dominate the market – JP Morgan, Citibank, Bank of America and Goldman Sachs.