How to Avoid another Derivatives Crisis
Risk management for emerging markets
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This October will mark ten years  since the derivatives crisis, an unprecedented event in Mexico that caused sharp losses and put large listed companies, such as Comercial Mexicana (formerly, Comerci) – which entered into bankruptcy proceedings –, Vitro or Gruma, among others, on the brink of liquidation. These companies failed to measure the risks they were taking properly and used these financial instruments to speculate, instead of as hedges.

The losses reported by companies and financial institutions caused enormous alarm and concern in society, as well as debate and confusion on the appropriate use of derivatives instruments. Were derivatives responsible for these losses or was it simply their poor management? The fact is that while derivatives securities can effectively control and hedge financial risks, their uncontrolled use can be very dangerous.

The chapter “Derivative Products in Emerging Markets and Prudential Regulations”, included in the monography Emerging Markets: Recent Developments, Challenges and Future Prospects (Nova Science Publishers, Inc., New York, 2018), examined the recent changes observed in derivatives trading in emerging markets, such as Mexico. In my experience as a practitioner and researcher of risk management and derivative products, I analyze the main obstacles to the adequate use of these instruments and offer practical recommendations for the use of efficient operational platforms, rigorous regulations and effective surveillance to discourage delinquencies and rogue trading within the financial service industry.

The attraction of emerging markets

Since the early nineties, emerging countries have played a key role in the derivative and structured products markets. These countries are characterized by their political instability and lack of regulations or historical financial data. But, far from being an obstacle, their enormous volatility is one of their attractions for both speculators and hedgers.

Volatility is the most important factor for the valuation of "options contracts" on any financial and non-financial underlying assets. In fact, derivatives products are only of value in an environment of uncertainty (volatility or risk), which is precisely why they are so good at hedging the risk of unexpected fluctuations in the prices of typically volatile assets, such as: government and corporate bonds, raw materials, currencies, shares and market indices.

Derivatives do not reduce the inherent risks of volatile assets, but rather transfer the risk from a hedger to someone who is willing to assume the risk, such as speculators or risk-takers. Since the beginning of the seventies, derivatives securities have been used more and more often for hedging and investment purposes.

Why do companies use derivatives products?

Companies usually use derivatives products to:

  • Separate specific financial risks from the function of financing or investment of financial instruments. For example, a company that is financed with variable rate debt can avoid the risk of an increase in the cost of the debt simply by contracting a swap contract.
  • Reassign risk (i.e., dividing and sharing risks). This makes it possible to complete projects that are too risky for an investor or individual entity.
  • Implement investment strategies less expensively than in cash markets through the purchase of futures contracts on market indices.  
  • Reduce borrower costs by allowing counterparts to negotiate their competitive advantage.
  • Hedge transaction exposure in confirmed import/export transactions or debt issue.
  • Protect expected cash flows or the company’s value from fluctuations in financial and raw materials prices.

An approach for emerging markets

Nevertheless, emerging markets have a set of characteristics that require different risk management approaches from those used in developed countries. For example:

  • Negotiated securities are, in many cases, insufficient to establish suitable benchmarks and historical data for the valuation of certain operations, such as swaps contracts.
  • Calculating the “implied volatility” of options prices as a benchmark is a challenge, given the few options of securities in currencies, interest rates, raw materials or market indices that are  frequently negotiated.
  • Emerging markets are characterized by recurrent government interventions in financial markets to stabilize the short-term impact of a current event or crisis. In these situations, risk calculations require estimations of the possible fall of financial markets in case of a possible crisis or event.
  • The investment risk is lower in information technologies and talent with technical training in economics and finance, such as traders, arbitrageurs, quantitative analysts and risk managers.

Moreover, for derivatives markets to function in emerging countries, the following is required:

  • Liquid cash markets that function satisfactorily and well-founded credit and financial institutions with a substantial number of traders, speculators and hedgers.
  • A legal structure that includes a system of property rights and credible commercial contracts.
  • Support from the local government and legislators, and adequate financial resources to create successful derivatives clearing houses.
  • Absence of similar derivatives products that compete in transactions with well-established foreign derivatives.

In general, a greater understanding of derivatives products and their risks is needed. As mentioned beforehand, this can be accomplished by implementing a series of institutional changes that will help to reduce uncertainties in derivatives and structured securities.

In an increasingly integrated and changing world of financial markets, improved management and closer supervision of derivatives positions is preferable to the formal regulations centered on specific instruments, markets or participants. Logically, this must be combined with a clearer legal framework, well-established risk management and accounting regulations that control their use, as well as a greater dissemination of derivatives and structured products.