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Whomever wrote the derivatives article in the Contrary Investor website was correct when stating "We are not experts in bank derivatives activities by any means" and "Again, we are not derivative geniuses.....".

A common error in the press is to lump all derivatives into some bogeyman category, usually with a reference to the Orange County, California debacle. Orange County's inverse floaters and other highly-leveraged and relatively illiquid speculative derivatives comprise only a very tiny percentage of the derivatives market.

Derivatives fall into two categories: 1) speculative instruments, and 2) financial engineering risk management tools. Quoting the Contrary Investor article which quoted the OCC Report:

"The banks with the 25 largest derivatives portfolios hold almost 97% of their contracts for trading purposes, primarily customer service transactions, while the remaining 3% are held for their own risk management needs."

"Customer service transactions" means that the deals were done with customers ( corporations, public entities, downstream smaller correspondent banks). The "own risk management needs" statement means for managing - not increasing or leveraging - existing interest rate risk primarily due to asset-liability mismatches.

That only leaves a very small percentage, whatever portion of the 97% that was not included in "primarily", as their own speculative risk trading. All publically traded banks provide information on risk trading limits and parameters, and they are usually well-defined, very explicit and continually monitored throughout the day. In addition, they are marked-to-market and the gain/loss recognized daily.

Risk management derivatives (RMD) are what allow banks to offer individuals adjustable rate mortgages. These mortgages have an embedded cap that sets an absolute cieling over which the borrowers mortgage rate can not go. RMD are what allows banks to make 30-year mortgages when depositors (primary source of funds) do not invest in 30-yr bank deposits or even 7-10 yr bank deposits (average duration of a real estate loan). RMD are what allow banks to offer customized solutions for corporations' financial needs, from loan structure and terms to managing foreign currency risk related to international trade and investment. If entities could not and did not manage this risk THEN we could have a very serious domino debacle in a rapidly changing interest rate environment.

For the OTC versus exchange-traded argument, there are pluses and minuses to both. First, the largest market in the world is the foreign exchange (FX) market (source-NY Fed Reserve). The exchange traded FX futures are standardized contracts in only a few currencies. They are on-balance sheet items that are not suitable for the needs of the international trade community or even most of the FX speculators. Corporations want to buy or sell their currency at risk, with delivery on a set date, in a specified amount, at a specified rate, and there must be delivery at settlement. Can't do any of this with FX futures. Therefore, the OTC market for FX forwards (an off-balance sheet derivative) exists. It is very liquid with excellent price transparency, and has about $1.6 trillion turn over every day.

Futures of any sort are only exchange-traded. Options are both although except for FX options, the majority of volume is still done on the listed exchanges. For the second largest derivates market of swaps (I have floating rate debt and I want to "convert" to fixed and vice versa, or my floating rate debt is LIBOR-based and I want to "convert" to Fed Funds based), there is no listed exchange. By their nature swaps are and will most likely remain only an OTC derivative.

If a derivative is very exotic, extremely leveraged or risky, and thinly traded, it will not have a lot of price transparency and liquidity will most likely be an issue if the purchaser wants to get out of the contract early. OTC has more credit risk because it is just 2 trading parties. However, banks hopefully do a thorough job of credit evaluation and few allow speculative derivative activity from customers, and the customers hopefully chose their counterpart carefully. Personally I would pick a major bank over a brokerage or boutique house like LTCM any day.

For most non-speculators, OTC is better because it can be customized and has more varity and flexibility. Finally OTC allows the counterparties a measure of confidentiality that the exchange-traded market does not. Few corporations want their major competitors to know or be able to guess all financial details.

For reporting notional values are used and positions are not netted. For example if Company A bought $10 MM worth of Swiss francs from Bank X, and Bank X covered their resulting exposure by doing an exact offset deal with Bank B, Bank A still has to report $20 MM. Similarly if Company A wants to add a swap to convert its variable rate index on its $50 MM loan to a fixed rate and Bank A offsets it in the market, Bank A reports $100 MM even though on swaps only net interest index payments flow among swap counterparts. At least with the FX forwards the full principal amount flows. So, as you can see, that one notional amount reported has little value except to excite readers.

If I was the Contrary Investor, I would be much more worried about the non-banks that are using the highly-leveraged derivatives to take risk rather that the money center banks who use them to manage their own risk and help their clients manage their risk. As an investor, I do look to see what sort of financial risk companies I am interested in have and check to see what they are doing about it. I want the companies I own stock in to focus on and be viable based on the business they are in and not to take excessive foreign exchange and interest rate risk which could result in a huge windfall or a huge loss (look at what sunk Flying Tigers). I want them to use derivatives where it makes financial sense and not to where it doesn't.

Also, if I was Contrary Investor, I would go to my library or local bookstore and get "Financial Derivatives" second edition, by Robert W. Kolb of the University of Miami. Publisher is Blackwell. After I read it I would have a much better understanding of derivatives and could write articles that better benefitted by readership.

Sorry this is so long, mlw
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