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Investment view

It seems that the sage of Omaha is in the news again as a consequence of one of his pithy sayings. Over the years, his letters to the shareholders of Berkshire Hathaway, the investment company he heads, have been a source of great inspiration. In 2001, he dismissed the technology boom (which by then had descended into bust) with the apposite comment that “nothing sedates rationality like large doses of effortless money”. How right he was.

I wonder how right he will turn out to be this time. Warren Buffett&#39s reference to derivative instruments as “financial weapons of mass destruction” has brought howls of protest from those involved in this multi-trillion dollar industry that is barely into a third decade of proper existence. The comments, it appears, were stimulated by problems at a Berkshire Hathaway subsidiary. Still, his remarks will have resonated with those who have been on the receiving end of derivative trades that have gone wrong. There will be also those who have suffered because of derivative losses without even realising the source of the financial pain. So, is he right to be concerned about a market where the turnover exceeds that of the underlying cash markets many times over?

Derivatives in some form or another have been around for a long time. When I first ventured on the floor of the Stock Exchange in the early 1960s, share options were a flourishing market. Options then lasted for a fixed three months and gave traders an opportunity to speculate on share price movements. It was not long after that the traded options market developed. Of course, the opportunity to buy currencies and commodities for future settlement was already in existence. It was the development of formal derivatives&#39 exchanges in the US and UK in the late 1970s and early 1980s that really got things off the ground.

Perhaps the first serious derivatives&#39 blip came during the 1987 crash. Price movements here were distorted by the fact that the UK market remained closed on Friday, October 16 because of the effects of the hurricane that ripped through Southern Britain the previous night. On the Monday, when the London stockmarket reopened, traders had to cope with a disastrous Friday on Wall Street and, as it happened, an equally turbulent Monday.

The authorities in New York recognised that the derivatives market had exacerbated the collapse of share values. In Hong Kong, it was even more serious. Trading ceased for much of that week and the mighty HSBC had to step in to provide liquidity. A consequence was for the US regulators to amend the rules and impose a system of circuit-breakers to limit any damage the derivatives market might do in the future and to ensure that greater balance was maintained with the cash market.

Notwithstanding that, periods of great volatility can take place when futures contracts expire. The most intimidating of these events is known as the triple witching hour. Expiry of a number of contracts at the same time can produce wild swings in the cash market. We should not forget the perceived threat that LTCM posed to the American banking system when it collapsed in 1998. Whether or not derivatives could be responsible for mass financial destruction, they can certainly be upsetting.

But it is their use in retail financial products that gives me the greatest cause for concern. Given the way in which markets have been in such disarray, it is hardly surprising that guaranteed and structured products are presently so popular. Yet this is not a recent phenomenon. The opportunity to buy something with a “guaranteed return” has always proved a strong selling point.

As markets roared ahead in the 1990s, the practice of creating packaged products to deliver returns based upon performance of an underlying stockmarket became increasingly popular. They were conceived and sold at a time when bear markets appeared to have been vanquished. The small print for a number contained warnings that not all the invested capital would be returned if the index in question suffered a fall of a certain magnitude. In many cases, the falls have been significantly greater and many investors may be discovering that reading the small print is always wise. Weapons of mass destruction? Possibly. Financial instruments that should be used with care? Definitely. Particularly by unsophisticated investors.

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