At Thirty: Derivatives, Practices and Principles

At Thirty: Derivatives, Practices and Principles

Published on February 14, 2023

Thirty years on, the Group of Thirty’s seminal study on derivatives remains the operating guide to which all businesses engaged in derivatives trading should adhere, but all too often have not.

Recently, I recorded a Podcast and published an article to review one of the major oil trading debacles of the 1990s, that of Metallgesellschaft Refining and Marketing (MGRM). This year is the thirtieth anniversary of their announcement of $1.3 billion in losses from trading in the oil futures and swaps markets. This event shocked the global oil trading community and corporate Germany.

MGRM’s physical oil business had deferred physical oil sales that needed to be hedged (to cover their shorts and lock in their profit margins). But unfortunately, their trading desk employed what turned out to be a highly ineffective risk management strategy which eventually led to the company’s downfall: The mark-to-market on their derivatives positions drained all their liquidity, and the eventual unwinding of their trades culminated in staggering realised losses, destroying one of Germany’s largest industrial conglomerates in the process. In the 30 years that followed, there have been countless commodity trading debacles, many involving derivatives trading: But are derivatives a problem?

Derivatives are financial contracts whose value depends upon an underlying financial asset or commodity price. Futures markets had existed in some form as far back as 4000 BCE when the people in Sumer (modern-day Iraq) used clay tablets to denote the number of goods to be delivered on a predetermined date; this is often cited as the first evidence of a ‘futures contract.’ However, the Swaps market (on any asset) is barely forty years old and came into existence in 1981 when Salomon Brothers facilitated an exchange between IBM and the World Bank in the currency markets. Swaps are derivatives executed bilaterally between two counterparties in the Over-the-Counter market. This market expanded exponentially over the next forty years; big financial explosions would occur periodically.

The futures and swaps markets allow consumers and producers of commodities to hedge unwanted commodity price exposures. This gives them the certainty of cashflows in their operations by locking in input costs or guaranteeing profitable production or extraction margins. Moreover, these markets are also open to the investor and speculator communities. Investors can utilise the same financial tools to create commodity price exposures to express a view on the price of those commodities (or a commodity-related outcome). Given a list of an unknown entity’s futures and swaps positions without knowing their business, it is impossible to determine if they are hedging or creating risk.

Derivatives became a household name during the 2008 Global Financial Crisis when credit derivatives nearly collapsed the entire global financial system. While derivatives were often blamed, and Warren Buffet’s infamous 2002 quip about them being ‘financial weapons of mass destruction’ would be constantly repeated, it was falling US house prices and pitiful lending standards of mortgage providers that would precipitate the crisis. The crisis was exacerbated by the leverage that derivatives themselves bring; their excessive use, the poor regulatory oversight of banks in general, and ill-suited risk management metrics that would fuel the crisis further. Check the financial filings of Berkshire Hathaway (Buffett’s company). You will see that derivatives have been employed for decades by Mr Buffett and that his original quote (in its entirety) referred to the need for proper management and oversight of those engaging in the use of derivative products.

In July 1993, only six months before MGRM would announce catastrophic losses in their derivatives trading, a report was published by the Group of Thirty (G30) called Derivatives: Practice and Principles. The G30 is an independent global body comprised of economic and financial leaders from the public and private sectors and academia who aim to deepen the understanding of global economic and financial issues and explore the international repercussions of decisions taken in the public and private sectors. To this end, they commissioned a study consisting of recommendations on what derivatives are and how derivatives work, their uses and best management practices, including accounting and staff oversight. The study also recommended four ways that supervisors and regulators, for their part, can help the financial infrastructure keep up with derivatives activity.

The then Chairman of the Group, former Fed Chair Paul Volker, succinctly lays out the reasoning for the creation of the study in his introduction. The study is written in plain language and is neither an excessively long academic tome nor a complex legal treatise. Instead, it consists of 24 recommendations for Dealers and End Users of derivatives that, even today, are only sometimes adhered to; I wonder if anyone at MGRM read it?

Recommendations broadly sit under several key headings: Valuation and Market Risk Management, Credit Risk Measurement and Management, Enforceability; Systems, Operations, and Controls, Accounting and Disclosures: These are all vastly important when managing derivatives activity. However, under the General Policies section, the first recommendation is critically important and is constantly called into question when a financial catastrophe occurs: The Role of Senior management.

From the study:

…Dealers and end-users should use derivatives consistent with the overall risk management and capital policies approved by their boards of directors. These policies should be reviewed as business and market circumstances change. Policies governing derivatives use should be clearly defined, including the purposes for which these transactions are to be undertaken. Senior management should approve procedures and controls to implement these policies, and administration at all levels should enforce them…

Boards of directors are not supposed to be directly involved in companies’ operations. Instead, they protect shareholders by ensuring that the right talent is employed and that early warning systems are in place to identify risks and catch exposures before they become too large. The right talent includes the executive management and those they hire to engage in derivatives trading. In addition, those executives and managers must fully absorb the study’s recommendations and build their trading infrastructure accordingly: This will lead to proper derivatives use through deeper understanding and adequate supervision of all trading and trade-related activities (which could also help minimise trading-related fraud).

When financial calamity occurs, multiple failures across the business’s functions are often identified (this has also happened in all recorded accidents at nuclear power plants, it is never one thing but a series of small failures, the Three-Mile Island being the best example). With hindsight, the signs are nearly always there, yet they go unnoticed or ignored.

Inquisitive and educated support staff are just as important. Irrespective of roles or focus on the trading operation, it is essential to have a team with a solid understanding of what the derivatives trading business does and how it should function. It requires character and bravery to speak up (to senior management) when something is misunderstood or does not make sense. I am reminded of the NYC anti-terror subway slogan ‘If you see something, say something.’ This rule equally applies in trading derivatives: A culture of fear was cited as one of the many failures around the China Aviation Oil trading losses in 2004 ($550 million).

Another primary subject that is also often at the heart of derivatives problems is that of pay. Remuneration must be structured for all employees in such a way as to dissuade taking any action that leads to personal gain at the expense of the organisation for whom they work. In contrast, remuneration is not a vital feature of the study. Still, a firm understanding of derivatives will allow remuneration policies that align with the company’s long-term goals.

Derivatives can be confusing and complex, but they serve a real economic purpose to myriads of market users. Therefore, thoroughly researching the derivatives business, irrespective of how daunting it might first appear, is necessary for protecting your company if you are to engage at any level in derivatives trading for hedging.

The G30 study is as relevant today as it was groundbreaking then. And judging by the number of financial blow-ups since (those not precipitated by fraudulent activities), quite a few other derivatives practitioners had not read it either.

After researching the G30 study and its utility as a derivatives guide, I was reminded of another guide that was first revealed to the world in 1978, the year the G30 was founded. It is known as ‘The Hitchhikers Guide to the Galaxy’. Whenever I encounter issues involving derivatives trades (over 25 years, there have been a few across all business functions and in most commodities), I think back to the first suggestion in that guide. It is written in bright red letters and reads: DON’T PANIC. It is good advice for everything but especially helpful when reviewing a derivatives position. During the many studies of the aftermath of MGRM, their senior management’s panic appears to have been partly blamed for exacerbating some of the trading losses.

It may be impossible to protect against fraud completely, and any trader with a risk limit might incur material losses during extreme market duress. But with proper risk metrics, training, systems and procedures in place, those risks can be reduced. The G30 report is a great place to start: It can be found here.

Kevin O’Reilly is an energy market risk professional and an independent thought leader in ESG and risk solutions in most commodity-related industries. He most recently served as the Chief Commercial Officer at Global Risk Management and spent 25 years working on Wall St. in Energy Banking, Trading, Sales, and Risk Management.