The dangers of financial derivatives

Although derivatives can have benefits in risk management, they can cause serious losses if not used properly - akin to a double-edged sword.

On the dark side, financial derivatives can create unproductive activities and lower transparency. While their risk-shifting function serves the useful role of hedging, facilitating capital flows, the increased use of derivatives also poses dangers to the financial system and economy as a whole.

The wide use of derivatives can and does lead to lower transparency between counter-parties and between regulators and market participants. They can be used unproductively for speculating, leveraging or raising risk-to-capital ratios, dodging and outflanking regulations, manipulating accounting profits and evading tax.

Due to the use of derivatives, the speed and depth of the impact on the financial sector and economy in the event of a large change in the exchange rate or other market prices will be greater. This increases the risk of systemic failure and the vulnerability of the sector and the economy.

Derivatives lead to transparency problems in two ways. They can distort the meaning of balance sheets as the basis for measuring the risk-return profile of firms, central banks and national accounts. When traded or booked, over-the counter derivatives lack adequate reporting requirements and surveillance. This results in distorted market information.

A bank may have derivatives that bet considerably on the interest-rate levels in the financial markets and create contingent liabilities and potentially harmful losses. These derivatives then substantially alter the bank's risk exposure from that reflected in the balance sheet. This is what happened recently with one state-owned bank.

Lack of transparency can be created at the central-bank level, for example when a central bank reports the value of its foreign reserves but not the  foreign-currency derivatives through forwards and swaps. This can mislead the public about the true level of the bank's reserves and its ability to intervene in the forex market. Just such an incident actually happened in the case of the Bank of Thailand's disclosure of its forex positions in 1997, which resulted in serious losses for the country.

Derivatives can sometimes be used to outflank prudential regulations as well as to manipulate accounting rules, to dodge restrictions on forex exposure on financial institutions' balance sheets and to lower capital requirements. For example, structured notes are sometimes designed to manipulate accounting rules so that high-yield notes can be treated like top-rated credit instruments for assigning capital charges. Derivatives can also be used so that payments, receipts and income can be shifted between periods. This was used by one Thai bank that later suffered devastating setbacks.

Chodechai Suwanaporn is the director of the Fiscal Policy Office's financial systems section. Views expressed here are his own.