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Financial derivatives are a double-edged sword. Understanding and using them well, derivatives can be valuable investment tools, and effective risk management and mitigation instruments. Misunderstanding and misusing them can lead to amplified losses. Over the decades, there have been many documented and undocumented derivative losses. Table 1.2 lists some of the well-known and high profile cases dating back to early 1990s. These derivative losses resulted either from outright wrong and misunderstood positions or from unwinding losses because of forced margin calls.

Table 1.2 Sample derivative losses

Derivative Losses

As can be seen in Table 1.2, derivative losses have happened frequently in the past. While the frequency of these occurrences may have become less on average, the individual loss amount has actually become larger. This indicates that lessons have not been learned fully. Derivatives are highly leveraged instruments. One must fully understand the risky nature of the derivatives as well as their practical operational details. It is essential to build adequate technical and operational frameworks before embarking on highly leveraged activities. Derivatives business should consist of a comprehensive set of technical, risk management and operational control tools.

Table 1.2 does not include rogue trading that occurred at Barings, Société Générale and UBS. For completeness, they are listed in Table 1.3 and it is striking to see how similar they all look. The last column shows one of the common features of rogue trading; they all involved liquid index futures. Strong internal operational control is the key to prevent such rogue trading activities.

Table 1.3 Derivative rogue trading losses

Credit Crunch and European Debt Crisis

The banking landscape has changed forever following two major financial crises: the sub-prime triggered credit crunch in 2007/08 and European sovereign-debt crisis in 2012/13. Both crises led to the freezing of the global credit market. Derivatives were certainly not the cause of the crises, although in some cases they were misused. Many lessons can be learnt from the analysis of how the crises happened, as can be seen in Table 1.4.

Table 1.4 Financial crises and their causes

Direct financial losses incurred by the financial institutions were massive during the crises. The losses in many large banks were running into tens of billions each. Ironically, the losses due to traditional banking activities such as (bad or excessive) lending were many magnitudes higher than the derivative losses if compared like-for-like, even though derivatives are perceived as more risky by the general public.

In the aftermath of the financial crises, financial institutions started fundamental changes and repositioning to de-risk and de-leverage. For example, one bank's leverage ratio (total assets exceeding tier 1 capital) was reduced from 68 times in December 2007 to 44 times in December 11. High leverage means high volatility in P&L, resembling derivatives. Leverage itself is a derivative on society, and too much of it will expose the economy.