EXOTIC derivatives are generally referred to derivatives not on the menu of normal financial-derivative packages. As in the Thesaurus, “exotic” is “mysterious,” “outlandish,” “strange,” or even “exceptional” so that these derivatives are packages where one needs to be careful with and skeptical about.
In the 1990s Procter & Gamble Co. and the Orange County of California lost $157 million and $1.5 billion, respectively, in exotic derivatives. In 1995, due to poor oversight, poor choices and through exotic derivatives, Barings Bank lost $1.3 billion, which resulted in the bankruptcy of the financial institution founded in 1762.
In 1997 Robert Merton and Myron Scholes won the Nobel Prize in Economics for their contribution to the profession—their methods in derivatives valuation by using the Black-Scholes model in pricing a derivative called options. Roughly a year later, a company they directed and managed, called Long-Term Capital Management, lost $4.6 billion in four months, the biggest bankruptcy of the 1990s. Thanks to the use of the Black-Scholes model.
More recently, it got crazier! In the latest global financial crisis, American Insurance Group—the world’s largest insurance company and was “too big to fail”—lost $18 billion in a type of exotic derivative called credit default swaps (CDS).
These facts and many others have led Nobel laureate economist Joseph Stiglitz to propose to outlaw the use of exotic derivatives by the world’s biggest financial institutions. Warren Buffett, a known philanthropist and one of the richest men on earth, made a blanket statement that derivatives are “financial weapons of mass destruction.”
As exotic as CDS and other kinds of derivatives are, “exotic” means something strange and exceptional compared to something regularly known, the usual, normal and ordinary. For instance, derivatives, compared to normal financing like borrowing for interest, are, indeed, quite exotic.
Going back to the middle ages, borrowing for interest was already considered exotic. In fact, lending for interest, according to the Old Testament through the Book of Exodus, was a sin and illegal in terms of the Canon law. It is even more sinful if one charges an interest so high that it is already usurious and akin to loan sharking. What interest rate constituting usury is in the eyes of the Beholder. But these days, it is safe to say that the borrowing term “five-six” (5-6) already constitutes usury. That is: for every P5 I lend to Juan de la Cruz, he pays back P6, which equates to a 20-percent interest rate and, by modern Filipino norms, is already usurious.
Now looking back 600 or more years during the middle ages in Christian financing, there was an exotic financial scheme referred to as contractum trinius.
Suppose I sign a contract with Juan de la Cruz for a business partnership where I will invest P5. The contract, of course, is a partnership with the view of having shared profits and risks, which is true to its Christian spirit. Simultaneously, I sign a second contract, which is an insurance contract with de la Cruz. In the said contract, I pay him P0.1 as insurance: if business does not do well enough as it generates less than P6, he will entitle me to a claim of P6. That would be so Christian-like of de la Cruz for allowing me to pay cheap insurance premium. As for me, it would be so responsible to insure myself and my family of the P6 of assured future income.
Then simultaneously, I sign a third contract, which is a bonus contract. In this third contract, de la Cruz pays me P0.1 in exchange for him having the right to keep all revenues exceeding P6. As for me, it is so Christian-like generous to offer only P0.1 for what could be an eventual lucrative bonus. As for de la Cruz, he would potentially reap what he sows: “For to everyone who has, will be given more and will grow rich” (Matthew 25:29).
In the simultaneous signing of three Catholic Canon-compliant laws, bundling together gives us something before the 15th century that could be considered as exotic finance. The Canon law prohibited 5-6. I didn’t require 5-6 in the three contracts I entered into with de la Cruz: I invest P5 in a partnership and owe him P0.1 for his generous insurance. De la Cruz owes me P0.1 for my generous incentive-scheme so that all is quits. I get P6 if business becomes lucrative, but I get “only” P6 if the business doesn’t do good. But when all is said and done, the combination of the three contracts equates to 5-6!
In this day and age and according to common knowledge, borrowing for interest is conventional finance. The scheme that used to be exotic finance over 600 years ago has become conventional finance. We are sure that, at this time of immaturity, derivatives at least must be regulated.
As to the question whether exotic derivatives will eventually become conventional or outlawed, only time will tell. In view of history, we are not really sure. The best we know, at least up to this time, is that “exotic” is in the eyes of the beholder.
Luis F. Dumlao is former chairman of the Economics Department and senior fellow of Eagle Watch of the Ateneo de Manila University.