A Quick History of Derivatives
Derivatives are not new they existed for years upon years before 1991 however they get really interesting from 1991 on. So we will just jump right in and look at the history of derivatives starting with the year 1991.
Bankers Trust creates started using custom swaps (credit derivatives) in a big way with it's corporate customers.
Edward J. Markey, (D - Mass.) chairman of the House subcommittee on telecommunications and finance, asked the General Accounting Office (GAO) to study derivatives risks. That study would take two years.
Jin Johnsen Gibson Greetings treasurer agrees to buy a $30 million swap from Bankers trust based on the London Interbank Offer Rate (LIBOR). Gibson agreed to receive a fixed 5.5% rate and pay a floating rate squared (yes to the second power) and divided by 6%. The swap generates a $975,000 loss for Gibson.
Wendy Gramm (wife of Senator Phil Gramm) the chair of the Commodity Futures Trading Commission (CFTC) declare derivative products are legal using the exemption authority granted to the CFTC under the Futures Trading Practices Act of 1992. They also declared that swaps were legal even when entered into with offshore institutions that are outside of US law. Wendy Gramm would later leave the CFTC to become a director at Enron.
E. Gerald Corrigan steps down as president of the New York Federal Reserve and chairman of the Bank of International Settlements' Basle Committee on Banking Supervision. He cautioned that extensive use of highly specialized financial instrument derivatives are burdensome for accurate bank risk assessment.
John Meriwether started the hedge fund Long Term Capital (LTC) which consisted of the company Long Term Capital Management (LTCM). LTCM managed trades in the Cayman Islands registered partnership Long Term Capital Portfolio LP. The company trading strategy is based on the Nobel Prize winning economic models of Myron Scholes and Robert C. Menton.
"The Board is also concerned that derivatives activities could have implications for the stability of the financial system. Whether derivatives have increased or decreased systemic risk is still a subject of ongoing review and analysis. Derivatives have fostered greater awareness and understanding of risks and enhanced methods of risk management. It is clear, however, that derivatives activities have become a significant factor in the overall risk profiles of some banks and other financial intermediaries. Although these institutions are still relatively few in number, they are among the largest and most active in the financial and banking markets. If one of them failed to manage its derivatives activities prudently, its financial condition could be weakened, and concern about its financial health could jeopardize the smooth operation of financial markets."- Susan M. Phillips, Member, Board of Governors of the Federal Reserve System before the Committee on Banking, Finance and Urban Affairs, U.S. House of Representatives, October 28, 1993
The General Accounting Office (GAO) releases it's report on derivatives that was requested by Congressman Edward J. Markey. The GAO identified "significant gaps and weaknesses" in the regulatory oversight of derivatives.
"The sudden failure or abrupt withdrawal from trading of any of these large U.S. dealers could cause liquidity problems in the markets and could also pose risks to others, including federally insured banks and the financial system as a whole, In some cases intervention has and could result in a financial bailout paid for or guaranteed by taxpayers." Charles A. Bowsher, head of the GAO
Orange County goes bankrupt due to its failed bets on interest-rate derivatives.