Fighting financial fears
Risk happens, but there are ways to reduce it. Waleid Gamal Eldien* makes a case for financial derivatives
Since the opening shot of the Asian financial crisis in 1997, turmoil has resonated worldwide within financial markets with little hope for the restoration of stability in the near future. The attacks of 11 September added to the imbalances, due to both the initial aftershock and later costs of the "war on terrorism". With the growth of systematic risk, many local and international financial experts have been seeking to utilise financial derivatives contracts as a major component in risk management by means of risk transfer or mitigation techniques.
Under such pressures, local expert opinion has been divided over whether to push for the option of financial derivatives. Others are still unclear about their role, significance, application and implications. Financial derivatives can be simply defined as a financial contract that derives its value from an underlying asset, which can be either a real or a money asset. These contracts offer the holder of the contract the right to buy or sell the underlined asset at a predetermined price and date.
In spite of the fact that the concept of financial derivatives is firmly established in the world financial market, it has just been introduced to Egypt for the first time now that the government has opened debate on the proposed new capital market. The law would give the right to trade over diverse financial instruments in addition to stocks and bonds with the objective of continuing the development of the financial market and trying to keep pace with the swift evolution of global markets.
During the discussion phase of the new Capital Market Law, which should be presented to the People's Assembly within months, concerns were raised that the introduction of financial derivatives could actually trigger financial crises in Egypt. Some lawmakers believed that resorting to financial derivatives would harm the Egyptian economy because brokers would abuse them by speculating to earn swift gains, consequently amplifying risk or volatility in the Egyptian financial market. Moreover, the fact exists that people are still not well-informed about stocks and bonds, meaning that the level of ignorance would be even higher for these new financial instruments that are relatively complicated in their form and valuation.
Internationally, there is a growing tide of support for financial derivatives, as a number of former disbelievers have seen the light. For example, on 22 April 2002, Alan Greenspan, governor of the US Federal Reserve Board, who had been one of the most prominent critics of financial derivatives, surprised everyone by his testimony at the Institute of International Finance (IIF) in New York City. Included in his explanation of the relative mildness of the economic depression, compared to previous economic trends after similar shocks, was a favourable mention of the role of financial derivatives. With the development of the banking and financial system the emergence of new financial instruments can fulfil the needs of various kinds of investors. In this case, it helped investors to fully or partially hedge risks associated with their investments.
Furthermore, the development of these instruments through financial engineering maximised the benefits of the investor by tailoring financial instruments to match their investment sizes and future needs, additionally solving investment constraints set by the regulatory environment itself. This also aided banks in decreasing the risks accompanied by investment such as asset and liability duration mismatch, political or country risk, exchange rate risk, interest rate risk and price risk.
The simplest financial derivatives, generally referred to as "plain vanilla", include forwards or futures, options and swaps. These instruments have been developed through financial innovation to derive other more complex financial derivative contracts, which are more effective in satisfying the customers' needs compared to the previously mentioned derivatives. Important examples of these are barrier options, Asian options, CAPS and floors, which are contracts tailored to manage future interest rate risk. Also, there are many other types of exotic financial instruments, like the Hamsters. Some derivative contracts have been advanced to offer protection tools or credit enhancement through credit derivatives.
The rapid development of financial derivatives in recent years can be traced back to the advances in financial engineering and structured finance. Additionally, technological developments facilitated swift and efficient pricing, which led to minimised cost for trading these financial instruments in organised markets.
It should be noted that recent developments in the mortgage finance market in the US, which played a role in the economic boom of the 1990s, were due to different securitisation techniques like Pass-Through Certificates and Mortgage-Backed Securities (MBS). Also, Asset-Backed Securities (ABS) were developed and issued against future cash flow receivables -- through securitisation -- to finance projects, credit cards and exports. This takes place by issuing a security committed to pay a fixed or variable rate backed by an asset which will generate future receivables.
With Greenspan's about-face and other notable conversions among economic experts, the time is ripe to allow many simple and basic financial derivatives instruments to be traded in the Egyptian financial markets. There are some attendant risks with the use of financial derivatives, but these are nearly identical to those present in more traditional instruments like stocks and bonds, except that these risks may get more complicated in the case of merging more than one financial derivative contract (a so-called combined contract). The main risks include market risk, which relates to a large extent to the financial losses incurred in the value of the financial derivative, credit risk which is tied to the financial losses incurred by the owner of the contract if one party fails to complete its obligations due to bankruptcy or financial problems, and settlement risk that arises if the market is not deep enough or there is failure in the settlement mechanism.
There is also regulatory risk, which is loss resulting from a failure or absence or weakness in the norms or rules in internal control -- like fraud or the use of insider information. Legal risk could also be included, which is the loss stemming from a legal action which cancels the contract. Finally, there is systematic risk, which happens due to a crisis in the financial position of an entity dealing with financial derivatives, which could cause a contagion effect inside the banking or financial system.
Lately, Egyptian financial institutions have resorted to the use of some Plain Vanilla derivatives to hedge risks concurrent with investment, especially after the intensified local and international recession. The point here is not to attack these actions or stop these acts, perfectly legal from the point of view of market participants. The objective here is a request to the Egyptian government to head the charge in establishing an organised financial market for such instruments, which will require tremendous effort and time.
It is clear that this move will face challenges, but they can be overcome with the help of some international financial institutions like the World Bank (WB), the International Monetary Fund (IMF), the African Development Bank (ADB), in addition to the expertise of countries that already apply these financial derivatives. The challenges that should be addressed include the lack of laws and regulations to govern the trade of these instruments, the non- existence of an organised market to trade these instruments, the difficulty of accounting and auditing standards for these instruments, the difficulty of clearing and settlement of these instruments, the fact that the legal contracts of these instruments are not recognised in Egypt, and the lack of human resources in the different financial institutions specialised in these instruments.
It is not accurate to think, as some do, that financial derivatives necessarily lead to problems in the economic or financial body. No direct economic crisis has been linked to their usage. Additionally, to overcome the fear of some people that financial derivatives may contradict Islamic belief, work can be done to ensure these instruments abide with Islamic Law, as several Gulf States and Malaysia have done.
In all, nothing prevents Egypt employing financial derivatives as a primary means to fulfil the needs of investors and insure their capital using simple derivatives until we achieve a mature and efficient market ready to employ complicated structured instruments. If we do not accept their importance and significance now, especially considering the development of these instruments the last three decades, then we will be unable to realise our goal of making Egypt a financial hub for capital and investment in Africa and the Middle East.
* The writer is part-time instructor of finance at the American University in Cairo. The views expressed in this article are those of the author and do not necessarily represent those of the institution.
