Why derivatives are both good and bad weapons

In 2002, Warren Buffet described derivatives as ‘’financial weapons of mass destruction’’ in his annual investor report. Yet many insiders knew the 'Oracle Of Omaha' was playing the same game albeit quietly.

He’s since back-pedalled from his oft-quoted line. But that does not take away the wisdom of his words. Warren is right. Derivatives are a good tool if you know how to use them but a bad one if you don’t.

Sometime last year, a firm called Archegos went belly-up when they partially concentrated their investments in derivatives called total return swaps — this is the kind that allows one party to put up all the money for the purchase of stocks while the other party, without putting up any capital, agrees that at a future date it will receive any gain or pay any loss that the other party suffers.

This highly leveraged trading strategy also had a role in the fallout of Long Term Capital Management, a hedge fund that failed in 1998 and ultimately required a bailout from a consortium of banks to prevent a financial collapse.

One may wonder, if these highly experienced investors, who should know how to use these tools, can get ‘’creamed’’, are they any good for anyone let alone retail investors? The short answer is yes.

Derivatives are essential for any investor who wants to hedge a position, provided they’ve done their homework, understand how derivatives work and most importantly, are comfortable with the risks.

This explains why risk-conscious investors use them in both over-the-counter (OTC) and exchange-traded formats.

According to the Bank of International Settlements, their gross market value stands in trillions of dollars.

Now, if hedging is essential, the next question will be, how do I do it? Let's take a quick example. If one holds Sh1 million worth of Safaricom stock and they believe its market value is about to drop, to hedge against this risk, they will need to sell Sh1 million worth of Safaricom stock futures (if the underlying is KCB stock, this will involve shorting or selling KCB stock futures).

The advantage is that the hedge is done via a margin system (or leverage) meaning you only put up a fraction of the Sh1 million needed — this can vary between 10 percent and 30 percent of the total futures position depending on what the exchange determines.

But this is also where most problems begin. Just like any tradable instrument, abuse leads only to disaster.

This is exactly what happened in the years leading up to the 2008 financial crisis. Investors bet big on bundled mortgage bonds that eventually imploded, bringing down multiple major financial institutions and causing the worst economic downturns.

During this time, the value of derivatives rose more than 11 times higher than the Sh300 trillion or so recorded back at the turn of the century. Total OTC derivatives value, which accounts for the largest portion of the total derivatives value traded, hit just shy of Sh3.5 quadrillion in the second half of 2008 at their peak. Values have since come down quite considerably.

In sum, derivatives are open to all. Ideal in the current environment of volatility but are a double-edged sword. The benefits are immense but only with proper use.

Mwanyasi is Managing Director at Canaan Capital