Off-Exchange Derivatives Markets and Financial Fragility

Abstract

Huge losses suffered by users of off-exchange (or OTC) derivatives have created widespread concern that derivatives may be undermining the stability of financial markets. During the last 12 months alone companies have reported losing more than $10 billion on derivatives investments. A prime example is Metallgesellschaft A.G. (MG), Germany’s 14th largest industrial firm corporation, which reported losses of almost $1.5 billion as a result of a hedging strategy gone sour.¹ Only a massive $1.9 billion rescue operation by 150 German and international banks kept MG from going into bankruptcy. While MG did not default on its futures or swap obligations, had it done so the ramifications for some major international banks and for OTC derivatives markets in general may have been far-reaching. Substantial losses also have been reported by other large firms and investment funds: Orange County California ($1.5 billion), Showa Shell Sekiyu ($1.5 billion), Kash-ima Oil ($1.4 billion), Pacific Horizon Funds of Bank of America ($167.9 million), Procter & Gamble ($157 million), Air Products and Chemicals ($113 million), and Gibson Greetings ($19.7 million), to name just a few.² These incidents have left the clear impression that even sophisticated firms may not appreciate the potential risks associated with using derivatives, and that derivatives-related losses can be large enough to impair the solvency of even sizeable firms.