BEATING THE DEPRESSION: DERIVATIVES OR EQUITIES?

The current market and economic situation is a generational change in wealth. It will destroy the wealth many people have – or hoped to have – accumulated. It will also deliver the foundations of new wealth to other people. Investors face two challenges: first, they have to protect the wealth they have; and second, they need to participate in the creation of new wealth.

The answer to both challenges requires the same tools – derivative or equities. Derivatives were blamed for the start of the current financial crisis. The US Subprime Slime came from over-the-counter derivatives. These failed for many reasons.

The failure infected the financial system because of the belief that when risk is divided, it is isolated and reduced. The failure of one divided section should not affect the other sections. However, risk can be spread out but it cannot be eliminated. Risk must always be closely managed: it was not the derivative tool that brought disaster but the wrong application of that tool.

One of the most significant advances in recent years was the development of derivative products for retail investors. Some products were developed and endorsed by the exchanges, such as warrants, mini-futures contracts and exchange-traded fund products.

Other developments were the standardisation of some off-exchange over-the-counter derivatives such as spread-betting and contracts for difference. These derivative tools offer leverage, but they demand excellent risk management.

Derivatives are a way to increase capital in uncertain and volatile markets. Their first advantage is leverage. A small amount of money can be used to generate a larger return. This creates investment and trading income, and adds to the capital that can be used for investing in equities. Another advantage is the derivatives’ ability to trade short. This can be used to hedge or protect existing investments.

However, when market regulators disallow short trading, they leave investors with no option except to lose money. Faced with this situation, many investors will sell their stock, compounding the market’s fall. We saw this in China where the market collapsed dramatically partly because investors could not sell short.

Potential new investors will also shy away because regulatory limitations force them to only trade from the long side. Given the higher risk of losing their money, they simply stay out of the market.

Both these consequences take the liquidity out of the market and accelerates the downward pressure, depriving companies of the capital they need to keep the economy moving.
Derivatives created and managed by the exchange, or those approved and regulated by the exchange, are essential tools for investors who want to add cash capital into a depressed market environment.

Without capital and liquidity, the equities market will struggle. Investors must feel confident they can make money before they will return to the market. Investors must generate new money before they have the required capital to re-enter the market. Derivatives, when used correctly, can generate capital which can then flow back into the equity market as investments.

The markets have changed too much for these instruments to be abolished. Regulators and users must learn their lessons and curb unrestricted over-the-counter derivatives growth.
On their own, neither derivatives nor equities can beat the depression. A combination of both can restore liquidity, generate wealth and hasten the recovery of these depressing markets.
Regulators and market participants need to create conditions suitable for the sensible application of these instruments to preserve, protect and encourage efficient capital markets.

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The above was the speech text delivered by NextVIEW Chief Executive Officer Stephen Lai at the launch of the Asia Trader and Investor Convention (ATIC) held in Kuala Lumpur on 14 & 15 March 2009.

Stephen became CEO of NextVIEW Pte Ltd in May 2002 and has played a critical role in transforming NextVIEW from a home grown market data provider into a regional player in the financial information industry with direct offices in 7 countries in Asia. Stephen has professional work experience as an investment manager with an international fund management firm and in sales and marketing with a global financial information vendor.