Warren Buffett called them financial weapons of mass destruction! Thanks to financial derivatives, the financial economy is growing more dynamically than the real economy, and this gap is continuously widening.
Written by: Gordana Gelenčer
An inverted pyramid has been created where the sharp base is the real economy, and its superstructure is a mass of various securities circulating among global financial institutions. However, in such interconnected systems, where a Japanese, European, or Russian bank buys American derivatives, market shocks in the globalized economy cannot be contained within the limits of the ‘origin’. Today’s world is so interconnected that there are no local problems, as painfully confirmed by the latest crisis. Yet, even the crisis that is rumbling through all pores of economic life, now even in Croatia, cannot stop the thinking about the development of structured products based on derivatives – the very same ones that are causing large, unbreakable investment houses to collapse on both sides of the ocean.
Over time, interest in such products will awaken here, and most analysts do not agree that the Law on Securitization, which would ‘legalize’ derivatives, is still sitting in a drawer. The problem, allegedly, is not in the derivatives themselves but in the deficient regulation and poor oversight, which is well addressed in our law.
Interview: Iskra Kalođera Schmiedecke
* Do you think it would be worthwhile to introduce such structured products in Croatia now, in times of crisis, and would there even be interest in them?
– I think it would, because they already exist in some form; for example, Zagrebačka banka offers Integra. This is a structured product with capital guarantee. The biggest problem now in the crisis is: what if the issuer of such products goes bankrupt? You must have trust in the bank from which you buy such a product.
* Germany is the largest retail market for such structured products, not just in Europe. Has the crisis also ‘cleaned’ portfolios there?
– Clients are investing less now, but active clients know that with trust in the issuing bank, they can still buy structured products, as many have a safety component. There wasn’t time for me to talk about speculative products that you can buy on the futures exchange. I was talking about investment products with maximum equity risk or with less than equity risk. Why are these products interesting? When you get used to the fact that the stock market will not only rise, you say: I will take a structured product, and if the stock falls by 50 percent, I will still earn 10 or 15 percent. That is even more than what fixed-term savings in the bank offer. These alternatives with safety components are interesting even in a crisis. That is why they are so popular in Germany.
* What would you recommend to our future investors once these products are offered to them – to trade directly or through their bank?
– I think it would be best to consult with a private banker at the bank branch. In Croatia, investment decisions are still largely made based on advice. When the range of these products is available, it will be best for the private banker to recommend where to invest, which structured product would be best for each client. So, whether your bank or another issued such a structured product, your bank sells you a product with a guaranteed higher return than the interest on fixed savings. Even those prone to the least risk can still earn more than that.
* Which product would you recommend to someone who agrees to medium risk, and what about those who want a higher yield, thus are willing to take on greater risk?
– For those less inclined to risk, I would recommend a discount certificate, a product that costs less but offers limited profit. This is a product for individuals willing to take some equity risk, so even in the case of a significant drop in stock value, they will not incur as large a loss as if they had bought the stock itself. For those willing to take on greater risk, I recommend so-called knock-out certificates. They can allow for significant profit, similar to options, but they can also experience total loss. This is an alternative to futures, intended for retail clients with which you can speculate on both price declines and increases.
* Do structured products have a future in Croatia?
– They certainly do, but the market needs to be educated. The first to enter this will certainly be those who are already engaged in stock trading, as they are familiar with these forms of investment, but someone who does not know what the stock market is, we recommend not to venture into investing in guaranteed products.
Derivatives Most Developed in Germany
Perhaps that is why there was considerable interest in the presentation by Iskra Kalođera Schmiedecke from the Zagreb School of Economics and Management. She says that the market for structured products (certificates) in Europe began to develop more seriously at the end of the 1990s. The German market for such retail products has grown the fastest and today, with 150 billion euros, is the strongest in Europe. In 2001, there were only about three thousand certificates, and today there are as many as 370 thousand. The reasons for such demand lie in the philosophy of tailoring products to individual needs. Everyone will find a product in the offer with a risk level according to their own ‘endurance’.
What are structured products, actually? These securities are issued by financial institutions (banks), and on the balance sheet, they are recorded as liabilities, debt. Structuring is based on derivatives, instruments whose value depends on the value of another instrument.
In derivatives, the principal never changes ownership; rather, only the exchange of cash flows is agreed upon, the price difference is compensated, credit risk is offset, or the advantages and disadvantages of the underlying products from which the derivative is derived are compensated in some other way. However, they are most often used for opposite purposes, most often in speculative ways for risk-prone investors or as instruments for protecting the assets of conservative investors.
What are financial derivatives used for? Clients buy them for speculation, that is, consciously taking on risk by entering a so-called long position when price increases are expected, or a short position when declines are expected. They are also used for hedging or securing positions to reduce the risk of market price changes, but also for arbitrage, that is, making a profit on price differences by simultaneously investing in two or more markets. Clients like them because they allow for payouts that are not available when investing in traditional instruments, and market success and risk can be calculated more easily, especially in volatile markets, claims Iskra Kalođera Schmiedecke.
At the conference, she presented only a few, specifically investment but not speculative instruments, such as options, participation certificates, discount, bonus, and knock-out certificates.
