Derivatives and Risk Transfer

A great example of risk transfer in action is when people buy insurance to insure themselves against losses that they may not and usually cannot bear themselves. These losses may involve various levels of financial hardship or perhaps the person simply cannot manage the risk themselves at all.

If someone loses their home to a fire for instance, and be uninsured, sure they could start over again in some cases, but usually people will have a mortgage and they can’t just start over with the bank expecting them to forgive the loan or just add it on to a new mortgage that they will take out.

Mortgage lenders insist on the property being mortgaged being insured against these losses so that they are not left holding the bag when something like this happens. This is also a great idea for the borrowers as well as these are not events they can take on either.

So the homeowner transfers the risk of these perils to an insurance company, who, due to their much larger asset base, can take on these risks with this homeowner and many others and manage the risks.

The insurance company is going to have to worry about taking on too many risks as well though and will pass on a certain amount of risk to another company, called a reinsurer, because they insure insurance companies.

In the end, there is a certain amount of risk, the cumulative risk of property damage we’ll say, and the risks that the property owners cannot bear get passed on to insurance companies, and the risk that these companies cannot bear get passed on to reinsurers.

What this risk transfer accomplishes from a risk management perspective is to greatly reduce situations where those who bear the risk are unable to manage it properly, and transfers these risks to those who are in a better position to take it on and to manage it as it manifests.

There are two elements to risk transfer, cash flow and risk, and in our example the cash flow is the premiums that insurers charge those insured. So the risk gets passed on as well as payments.

It is worth it to pay the premiums because paying the premiums is a manageable way for insurers to manage the risk, and collecting the premiums and bearing the risk in exchange for them is a manageable and profitable way for insurers to operate.

This all allows for a more efficient way to manage risk overall, but it is not limited to insurance companies, and there is a lot of risk transfer in instances that are not insurance related. This risk transfer is accomplished by the use of derivatives, and all derivatives trading involves risk transfer, especially ones between institutions.

The Fundamental Nature of Derivatives is to Manage Risk

Many people have the perception that derivatives create risk in the market, and some even believe that they create a huge amount. Warren Buffet for instance has called the derivatives market a weapon of mass destruction.

While there may be some situations where this risk transfer can create more risk, for the most part what they do is transfer risks that already exist from those who are less equipped to mange the risks to those who are more able to do so.

An example of this would be the situation we had during the housing crisis of 2007 where we saw a massive number of credit defaults. When people default on debt obligations, there will be losses of course, and these losses need to be borne by someone.

The fact that a lot of these losses were transferred to some very large institutions that in the end became overwhelmed with the load was not the problem here. If this were not the case, if not for the transfer of risk that securitizing this debt promoted, we’d still be left with the defaults, which would have been borne by those less able to handle it.

This would have caused a lot more business failures and instead of seeing a few large institutions get put in deep trouble, a far greater number of smaller ones would have had to bear this loss. This could have resulted in a great many bank failures and a much bigger impact upon the world of banking than we saw, perhaps even causing a run on banks in general which could serve to greatly escalate the problems.

In times of crisis, people tend to want to point fingers, and a lot of fingers were pointed at these large institutions and the derivatives markets that allowed for these risks to be concentrated so much with them.

Whether we should use more regulation to look to prevent these institutions from taking on too much risk is a separate issue. Having anyone take on more risk than they can reasonably handle is one of the main things that financial regulators seek to prevent.

It’s pretty clear that this is what failed here, and there are always reasonable limits to how much risk an institution can take on. We do need to make sure that they do not take on excessive amounts, but this does not in any way mean that they should not take on the ones they can handle and take risk off the hands of those who cannot handle it.

Proper Risk Transfer Yields More Efficient Markets

To the extent that regulators and the public want to see us properly manage risk, we need to understand that derivatives markets play a central role in this. To the extent that we manage risk properly, this allows for an expansion of markets overall due to the greater efficiency that these risk transfers propagate.

An example of this is with consumer credit, where one can borrow at lower rates due to their lending institutions being able to pass some of the risks involved in lending to larger and more well heeled institutions.

We do need to be wary of the potential for excesses though if this risk transfer is not properly regulated. We cannot assume that large financial institutions will always regulate themselves properly, because we know that this sometimes is clearly not the case. There are temptations within these organizations to drive profit without enough regard to risk, and the job of regulators is to work to prevent this.

If an excess of risk is transferred, for example with what we saw with mortgage backed securities prior to the housing crisis, this can result in excessive borrowing which tends to go beyond reasonable limits and increases default rates, therefore increasing risk overall.

That’s not what the goal needs to be with risk transfer though, it should instead be used to add stability to various markets. While this does represent a big benefit to large financial institutions, risk transfer also benefits businesses and individuals as well, both of whom have the means to transfer risks of their businesses and personal portfolios through the proper use of derivatives.

Risk Transfer and Speculation

There is also a fear that by transferring risk more efficiently this may end up driving an excessive level of speculation. Speculation is actually the opposite side of the coin of risk transfer, and this is present in all financial trading, including buying and selling stocks.

When someone sells a stock they previously owned, they are transferring the risk of future price movements to the buyer of the stock, who then takes on this risk in the hopes that its price may move favorably and end up yielding the investor or trader a profit.

The difference with derivatives is that no exchange of assets or no ownership is involved and this is seen by some as just placing bets on things, with both sides speculating on the price movement.

There is nothing particularly preferential or fundamental about looking to reduce risk versus looking to take it on by speculating, for instance seeing those who are involved with the buying and selling of commodities being more important than those who just speculate on commodity prices in futures markets.

We may use derivatives to directly hedge risks, or we may use them to speculate, and both provide liquidity to markets. Banks exchange cash flows and interest rates and debt and other things, and some positions may be speculative and some may be based upon hedging, but the purpose of financial markets isn’t to promote one or the other, but to promote trading among those who wish to trade.

The fact that the nominal value of the derivates market well exceeds all the wealth in the world may trouble some, and those who do not have a well developed understanding of derivatives may see derivatives as a huge potential danger, but as big as the market is, with the proper degree of oversight, derivatives are very useful and serve a lot of important purposes that are very well ingrained in our modern economies and way of life.

Markets are always made more efficient when we allow the free trade of assets, and even positions based upon them, as is the case with derivatives. While we always want to avoid excesses, we also want to ensure that we do not constrain markets beyond what is necessary to have them operate in an orderly fashion.

When it comes to the risk transfer that derivatives promote, we want to make sure we allow risk transfer when appropriate, but at the same time not allow for anyone to take on more risk than they have the capacity to bear, especially when we’re talking about institutions that are seen to be too large to fail and require governments to come to their rescue in times of trouble.

Otherwise, derivatives convey much more benefits than most people realize, especially when you consider the sheer size of the derivatives market, involving nominal amounts up to 10 times the size of the total world nominal GDP. This amounts to a lot of risk transfer indeed, and serves a very important purpose in our economy to be sure.

The fact that we have this much risk transferred to parties who can better handle it is indeed a big benefit to us.