Chapter 1
Evolving Derivative Business Environment

The derivatives business has evolved in terms of customer needs, product ranges and models and infrastructure required for managing the derivatives products. It is a business that requires comprehensive understanding of the quantitative and organizational setup, and one must pay attention to the overall picture, as well as individual components.

Customer-Driven Derivative Product Categories

Derivative products are explicitly or implicitly embedded in many financial product types:

• retail structured products;
• insurance investment products;
• pension products;
• securitization products;
• real estate (property) products;
• etc.

There are many different ways to categorize customer-driven derivative products: by asset classes, by payoffs, by client sectors, etc. At the high level, they can also be categorized by the intended purposes of the derivative products, as seen in Table 1.1.

Table 1.1 Customer-driven derivative products

Category Intended Purpose Structured Derivative Products Structured derivative products are primarily intended for investment purposes. They offer investors alternative investment opportunities and access to new asset classes or markets. The buy side includes retail investors, high net worth and private banking customers, and institutional investors. Derivative Hedging Products Derivative hedging products are primarily designed for the hedging needs of institutional and corporate clients. They can be and should be used as effective risk management and mitigation tools. Large proportions of such products are interest rate hedging products.

Retail structured derivative products are by far the most varied in product types and payoffs innovation across all major asset classes, including equity, commodity, interest rate, FX and credit. Structured derivative products modify the risk/reward profile and hence the risk-adjusted returns. Their returns can therefore be better defined and clarified. One can also incorporate protection barrier features into many types of product to reduce the risk of losing capital.

Structured life insurance products also become popular in the low interest rate environment, whereby insurance companies look into new investment areas and products, in order to fulfil the promised coupons embedded in certain products. As life insurance institutions will be subject to Solvency II capital requirement, the products with low guarantee will attract lower capital requirement.

Structured derivative business has undergone profound changes over the years, in manufacturing processes and distribution mechanisms. The products become more tailor-made, coupled with the fact that distribution channels are moving towards e-platforms, which in turn encourages more individual product features. The manufacturing process encompasses product design, quantitative modelling, trading and risk systems integration, and validation. The overall process has become much more complex and infrastructures must also build in various required regulatory constraints. Therefore an integrated comprehensive manufacturing approach is vital to keep the whole process economically viable. The products' competitions have also been extended towards the longer end, from traditional short-dated (e.g. typically < 5 years) products to long-dated products, including pension products serving the ageing population.

Financial promotions of derivative products not only require the sell sides to get facts right, i.e. what the product does, what the cash and tenure commitment is it is also a compliant requirement to explain clearly to the customers the risks involved. Setting a strict and high standard on products and their risk management ensures a sustainable product design process which is vital for the long-term success of the derivative business.

Lessons in Derivatives and Crises

Financial derivatives are a double-edged sword. Understanding and using them well, derivatives can be valuable investment tools, and effective risk management and mitigation instruments. Misunderstanding and misusing them can lead to amplified losses. Over the decades, there have been many documented and undocumented derivative losses. Table 1.2 lists some of the well-known and high profile cases dating back to early 1990s. These derivative losses resulted either from outright wrong and misunderstood positions or from unwinding losses because of forced margin calls.

Table 1.2 Sample derivative losses

Decade Organization LOSSES Transactions 1990s Metallgesellschaft $1.3 billion Energy futures 1990s Codelco $207 million Copper futures 1990s Cargill (Minnetonka Fund) $100 million Mortgage derivatives 1990s Kashima Oil $1.5 billion Currency derivatives 1990s Procter & Gamble $157 million Leveraged interest rate and currency swaps 1990s Askin Capital Management $600 million Repo and mortgage derivatives 1990s Air Products and Chemicals $113 million Leveraged interest rate and currency swaps 1990s Piper Jaffray Cos. $700 million Mortgage derivatives 1990s Sears $237 million Swaps 1990s Orange County, Calif. $1.6 billion Leveraged repo 1990s Capital Corporate Federal Credit Union $126 million Mortgage derivatives 1990s Sumitomo Bank $1.8 billion Copper futures 1990s First Capital Strategists $128 million Stock index futures 1990s Postipankki $110 million Mortgage derivatives and structured notes 1990s NatWest $90 million Interest rate options 1990s UBS $170 million Equity derivatives 1990s UBS $120 million Equity derivatives 1990s UBS $75 million Convertible bonds 1990s LTCM $500 million Leveraged spreads 2000s Allied Irish Banks $700 million Currency derivatives 2000s China Aviation Oil $550 million Commodity derivatives 2000s China State Reserve Co. $300 million Copper futures 2000s Hedge funds Undisclosed large sum Credit tranche baskets 2000s Credit Suisse $120 million Equity derivatives (Korea) 2009 A European Bank ?100 million Bermudan swaptions 2009 Brazilian Corporates $28 billion FX Tarfs (Real) 2009 Korean Corporates $4 billion FX Tarfs (Won) 2009 Citic Pacific $2.4 billion FX Tarfs (Australian Dollar) 2012 JP Morgan $6 billion Credit derivatives index 2013 A Portuguese entity ?450 million Exotic swaps with accumulating coupons 2014 Asian corporates $3 billion FX Tarfs (offshore renminbi)

Derivative Losses

As can be seen in Table 1.2, derivative losses have happened frequently in the past. While the frequency of these occurrences may have become less on average, the individual loss amount has actually become larger. This indicates that lessons have not been learned fully. Derivatives are highly leveraged instruments. One must fully understand the risky nature of the derivatives as well as their practical operational details. It is essential to build adequate technical and operational frameworks before embarking on highly leveraged activities. Derivatives business should consist of a comprehensive set of technical, risk management and operational control tools.

Table 1.2 does not include rogue trading that occurred at Barings, Société Générale and UBS. For completeness, they are listed in Table 1.3 and it is striking to see how similar they all look. The last column shows one of the common features of rogue trading; they...