Once again the derivative debate has hit the headlines. The collapse of the UK merchant bank Barings has highlighted the dangers that can follow on from the unrestrained use of these complex financial products, and has led to calls for tighter controls and new regulations governing their use.

Middle East institutions and investors will be happy to find themselves on the periphery as this debate rages. Few institutions in the region have embraced these financial instruments wholeheartedly. And last year’s turmoil in the financial markets has already led the institutions that offer derivative products to look more closely at their use.

Derivatives are financial instruments that are linked to the value of an underlying assets, such as bonds, equities, currencies or commodities, and are used to reduce risk or assume risk for extra rewards. They are not a new phenomenon, but it is only since the late 1980s that the development of more complicated products appears to have outstripped the ability of central banks to monitor them.

Hedging

The products can be used to good effect where companies want to hedge against large price or interest rate movements in the financial markets, and Middle East firms are no exception. Dubai Aluminium signed a contract in January which enabled the company to guard against a collapse in aluminium prices as it carries out an expansion programme.

If the price of aluminium falls below a certain level, Dubal is compensated by the US bank Merrill Lynch, which arranged the deal. In turn, the US bank benefits from price rises above a certain level. With this contract in place, Dubal has been able to offer guaranteed returns to shareholders even in the volatile aluminium market (MEED 3:3:95, Cover Story).

However, the company assuming the risk has to calculate where the market is going to move. And here things can go wrong. When the bond markets collapsed in early 1994 following the increase in US interest rates, many international institutions, including some in the Middle East, suffered because they had taken positions in the market that failed to anticipate the rise.

The Bahrain-based Investcorp scrapped its own derivative trading unit at the start of 1995, after running up losses mainly due to this turmoil in the bond market a year earlier. ‘To be a player, you need to commit a large amount of capital, which was beyond the risks our clients were willing to take,’ says Lawrence Kessler, a member of Investcorp’s management committee. The scale of loss was only enough to affect profitability, but not Investcorp itself. Traders would not have been able to build up positions which could possibly have endangered the institution, he says (MEED 27:1:95).

‘Arab financial institutions tend to have shorter lines of communication. So no one is able to take up crazy trading positions,’ says one leading Arab banker in London. Even if the will to move into the derivative market was there, no Middle East institution has the market positioning or global reach to offer the kind of highly leveraged position that brought Barings down.

But chief executives are likely to look more closely at the smaller hedging operations that they do offer. ‘This will add to the conservatism and concerns about derivatives, and this is wrong,’ the banker says ‘It is not derivatives per se that are the problem, it is their control.’

Subhi Benkhadra, product development officer at United Bank of Kuwait, designs investment products for clients using derivatives. ‘Derivatives are wonderful instruments,’ he says.

However, he distinguishes between the use of derivatives with limited exposure providing opportunities to hedge against market volatility, and the other, speculative end of the market. ‘Where derivatives are extremely dangerous is where they are used for pure speculation,’ he says. ‘Where there is unlimited exposure, we are not interested.’