Published: September 02, 2011
The global financial crisis has put derivatives firmly in the sights of regulators and media commentators, but for those who are charged with managing corporate treasury operations, it is important to cut through the hype and get a firm grasp of what these tools offer in terms of sound risk management processes.
In its simplest form, a derivative is a financial instrument which derives its price from another underlying component and its value is influenced by factors such as time and leverage. However, high profile international blow-outs such as Orange County (which in 1994 became the largest US county to ever go bankrupt on the back of poor treasury decisions) or Barings (which saw ‘rogue trader’ Nick Leeson lose more than $1.3bn speculating) have given the instruments a bad name.
Closer to home there was no shortage of criticism for South African Airways (SAA) and its ill-fated hedging strategy which saw the airline take a R9.8bn hit through financial markets instruments between 2003 and 2004. A lot of this criticism, however, may well be misplaced.
“If one dissects the facts around the SAA case for instance, derivatives themselves were not the bad guy, but rather the financial reporting around them which created the problems,” says Chris Paizis, Head of Corporate Distribution at Absa Capital.
In the case of Orange County or Barings, says Paizis, the derivatives were deployed without mandates and this had created fear and uncertainty for treasurers contemplating using these tools to manage risk.
“The first question I should be asking myself is what my risk management mandate is and then I should be asking myself if I understand it and am able to effectively communicate it,” says Paizis.
He uses the example of a basic forward exchange contract, which is an instrument which almost all treasurers will be familiar with. The contract is a form of a derivative, the terms and risks are clearly defined and the treasurer can work out with some degree of confidence and certainty how much volatility they are likely to face.
Over the last few years the derivatives market in South Africa has evolved significantly with a lot of investment in new products and technology platforms as well as improved regulatory structures. These include equity, currency, commodity, interest rate and agricultural futures which see significant volumes pass through their markets each month.
For a country like South Africa, which is heavily dependent on its resources sector but has limited sources for capital, commodity derivatives have provided an alternative opportunity for funding. While many market participants have focused on growth in the equity Single Stock Futures (SSF) market, which tripled in three consecutive years from 2005 to 2007, other markets have also grown significantly. Between 2001 and 2008, the interest rate derivative market in South Africa had grown by 412% in terms of average daily trade and by the end of 2007, the country had 9% of the total overall market share of over the counter (OTC) derivative trading activity in emerging markets.
On the whole this growth is encouraging but as with every growing industry, there are bound to be hiccups along the way. While South Africa was shielded from some of the more spectacular collapses seen in the international markets, it has had some bumps and bruises along the way as market participants have worked hard to understand the best use for these instruments.
Breaking down the mystique around derivatives further, Paizis draws an analogy around insuring a sports car such as a Ferrari. The driver needs to understand the value of the underlying asset, the risks they anticipate facing and how much protection they need to buy relative to the risk. Ideally you don’t want to have to tap into the protection but it is reassuring to know it is there. “What you want is a prudent and flexible risk management tool,” he says.
Many South African investors will remember back to 2008 where the SSF and Contracts for Difference (CFD) markets were rocked by derivative trades gone bad and will use this as a reason to avoid these instruments. At the time there were a lot of questions about whether they were properly regulated and were operating in sufficiently liquid markets. These criticisms are perhaps unfounded considering how highly South Africa ranks in terms of international benchmarks. In 2010 the World Economic Forum Competitiveness report saw the Johannesburg Stock Exchange ranked first out of 139 countries for its regulation. Other areas where South Africa scored highly included the financing through the local equity market at 7th, availability of financial services at 7th, soundness of banks at 6th and legal rights of investors at 6th.
Paizis points out that the interest rate market in South Africa is also very well developed and the country had developed a 30 year interest rate swap market before it had one for the 30 year bond contract.
Two areas where derivatives can be very helpful are around mitigating risks you don’t want to take in financial markets and secondly it can help change the profile of your debt, which can be a very useful tool for many cyclical industries. [[[PAGE]]]
The debt profile of a company can change dramatically if it is able to change its free-floating debt to something less volatile through a simple interest rate swap.
Another area where South African companies can be smart around the use of derivatives is in the foreign exchange market which has been particularly volatile over the last decade. Even in the last few months the currency has swung between R6.60 and R7.50 to the US dollar, making it difficult for companies to forecast. Those tasked with managing this volatility and risk may be arguing that by hedging they are essentially speculating with company money and adding risk, but in fact may be taking on great risk by not buying long-term protection. This becomes important in other African countries where the financial markets are under-developed and open to high levels of volatility, especially when this is coupled with limited liquidity.
With a number of South African companies looking to expand into the rest of Africa, they are increasingly turning to banks such as Absa Capital and parent Barclays, who have experience on the continent and knowledge of currency and debt markets to structure appropriate deals.
Another factor on the currency front is that the South African Reserve Bank (SARB) has indicated in the past that it has been uncomfortable with the relative strength of the rand. While there are questions about how much the SARB can actually do in the USD4bn+ a day USD/ZAR forex markets to limit this appreciation relative to a weakening US dollar. This could create issues for many export-driven entities such as the commodity producers.
One of the major criticisms of hedging strategies and the use of derivatives is that they can be costly for the client and the transactions are essentially structured in favour of the banks who win irrespective of which way the underlying markets move.
When one talks about derivatives and investment banks, there is often a perception that it is a ‘zero sum game’ where if the client loses on their hedge, then the bank is the winner. While there are instances where bank traders are involved in derivative speculation, structured products from Absa Capital don’t fall into this category. “Banks are not betting on the other side of the transaction and the best scenario is when deals go according to plan,” says Paizis.
When considering these costs, clients need to not only think about the upfront costs of the transaction but the ongoing costs over the life of the transaction. Clients who are seeking to reduce the upfront costs will need to be prepared to give away something – “there is no such thing as a free lunch” is applicable when hedging.
This is where strong relationships come in for treasurers dealing with their investment banks, particularly if the transactions are long-term in nature or are likely to be repeated down the line. If the bank understands what the client is trying to achieve over the long run, the correct products can be structured rather than trying to build ad-hoc solutions on an instance by instance basis. However, there does have to be some ‘give’ from clients if they are seeking to reduce their risk and that means not always approaching the problem from an upfront cost perspective. Looking forward, treasurers are likely to face a variety of regulatory challenges with regards to derivatives, Paizis says.
In response to the global financial crisis, global regulators have lined up the derivative market for a shake-up which will see tougher legislation and oversight introduced into the market. A myriad new regulatory bodies and new legislation are likely to be introduced over the next few years in attempts to reduce market speculation and volatility.
One example of legislation which is likely to impact on the use of derivatives is the introduction of Basel III legislation into the banking sector. This will have significant impact on not only lending, but the appropriate use of derivatives and even the types of products which the banks are creating. A second factor is the changing accounting regulations including IFRS which will also have a significant impact on how products are accounted for and treasurers need to keep up to date with the changes. This again is an area where solid long-term partnerships with your banker can assist.
On the plus side, there are plenty of reasons to invest in building your knowledge and relationships in the sector. With exchange control regulations being loosened, this is encouraging businesses and individuals to look at expanding their businesses and investment mandates to include international markets.
With Africa tipped to grow faster than many other international markets, there are benefits to being an early mover and positioning your business to take advantage of these growth opportunities. A key challenge which has been identified by market participants is that due to limited liquidity and market depth, African economies remain vulnerable to ‘hot money’ which can make interest rates and currency markets particularly volatile. This can make doing business tricky at all levels.
A deep derivative market, which is well regulated with sound products means that speculators, business owners and those interested in hedging themselves against market risk can be brought together in a viable market. Not only does this stimulate growth but it also makes sure that the growth can be maintained despite market volatility.
In essence the derivative market acts as a form of ‘self-insurance’ for these developing markets.
Derivatives may have a bad reputation in the press, but one has only to look at the volumes going through the various markets to realise that those events which make the headlines are outlying events and not ‘business as usual’ for those who know what they are doing.
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