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.) [...]]]> 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.)