Monday, November 20, 2006

Fiduciary WMD


"derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal" Warren Buffet

The global financial system has become more competitive and efficient as a result of extraordinary innovation in risk transfer products. The investment derivatives market has grown in size and complexity, driven by the demand for more sophisticated risk hedging as well as higher returns. Retirement plans and hedge funds have been the primary drivers. Retirement plans are taking a larger role in these markets to meet return objectives and fund managers/hedge funds are taking a larger role to post attractive returns and remain competitive and profitable.

The Bank for International Settlements reports that the notional amount of all outstanding OTC derivative contracts was $370 trillion at June 30, 2006, 24% higher than at the end of 2005 and 4 times larger than in 2000. Credit default swaps increased by 46%, interest rate derivatives grew by 24%, foreign currency contracts grew by 22%, while equity and commodity contracts grew by 17% and 18% respectively. The “net” market risk of these contracts, after accounting for offsetting exposures, increased 3%. This was a less astounding $10 trillion.

Being reasonably informed is a much harder task in derivatives than in other parts of the capital markets, especially in the OTC markets which are largely unregulated. Derivatives can be used for speculation or risk reduction. Speculation can be extremely risky because derivatives employ high risk leverage. Using derivatives to hedge portfolio exposures is less risky, though instability in correlations can create unintended risks. The DOL provided guidance on a fiduciary’s responsibilities for direct investments in derivatives.
“Investments in derivatives are subject to the fiduciary responsibility rules in the same manner as are any other plan investments. Thus, plan fiduciaries must determine that an investment in derivatives is, among other things, prudent and made solely in the interest of the plan's participants and beneficiaries. In determining whether to invest in a particular derivative, plan fiduciaries are required to engage in the same general procedures and undertake the same type of analysis that they would in making any other investment decision. This would include, but not be limited to, a consideration of how the investment fits within the plan's investment policy, what role the particular derivative plays in the plan's portfolio, and the plan's potential exposure to losses”.
Indirect derivative investments require fiduciaries to;
“obtain, among other things, sufficient information to determine the pooled fund's strategy with respect to use of derivatives in its portfolio, the extent of investment by the fund in derivatives, and such other information as would be appropriate under the circumstances”
Investment fiduciaries need to understand the unique risks (market, credit, operational, liquidity and legal) and opportunities posed by investment derivatives since they have the ultimate responsibility for determining if they are being suitability utilized for their plan and participants. What might have been a prudent due diligence process for derivatives a few years ago would certainly not be sufficient today. Fiduciaries should be especially aware that the current low yield environment motivates fund managers to amplify risk to improve returns.

The mind numbing complexity of the current generation of derivatives can easily disguise speculative activity and the endemic risks of derivatives for which plan fiduciaries can be held responsible.

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