Is it true that the unsung virtue of derivatives is embedded financing?

A recent report by the US consultancy Finadium lauded a paper by Professor Bruce Tuckman of the NYU Stern School of Business who wisely cautioned against too severely discouraging the use of derivatives through regulation.

The main argument by Prof Tuckman is that derivatives and forwards can provide synthetic positions that have equivalent risk exposures but are safer than leveraged cash positions because they do not require the funding of principal. Since funding is restricted to the short term, cash positions are exposed to rollover risk. As derivatives do not need principal funding, they are more stable.

Prof Tuckman makes the standard demonstration that receiving fixed on an interest rate swap is equivalent in terms of market risk to running a bond position financed by borrowing; buying a forward bond or bond future is equivalent to buying that bond and repoing it out to fund the purchase until the forward date; selling protection on a bond through a CDS is equivalent to buying that bond and repoing it out go fund the purchase until the maturity date of the CDS; and (à la Black-Scholes) buying a call option on a bond is equivalent to buying the underlying bond and repoing it out to fund the purchase until the exercise date. “Bond positions cannot be financed long term. Swaps [and forwards, futures, CDS and options] have less financing risk than levered bond positions!” Accordingly, Prof Tuckman proposes that derivatives complete markets by providing what cash instruments cannot: stable term funding.

Unfortunately, Prof Tuckman’s advocacy of derivatives as providing “embedded financing” is an illusion. He perceives derivatives markets to be somewhat like the flying Island of Laputa in “Gulliver’s Travels”, as self-levitating. However, they are, as the label on the can clearly states, “derivative”. Derivatives transactions need to connect somewhere with cash positions. Derivatives transmit the risk between long and short cash positions. Given the inherently lower transactions costs of derivatives (due to the reduced funding need), they can transmit risk can be across long chains of derivatives transactions. But ultimately there needs to be a long cash position at one end of such a chain and a short cash position at the other end. The need for cash anchors is ineluctable. Cash positions are required to hedge derivatives and arbitrage against such hedges ensure accurate pricing.

The fundamental link between derivatives and underlying cash instruments can be seen during crises. Derivatives markets do not continue to provide liquidity when the underlying cash markets seize up. And there can be no liquid derivatives market without a liquid market in the underlying (as well as a liquid repo market).  Prof Tuckman suggests otherwise on the basis of the behaviour of the basis between CDS and corporate bonds during the recent crisis. He observes that the basis, which was negative, widened significantly. This reflected the difficulty of arbitraging the basis once funding evaporated. In theory, one could reap the basis by simultaneously buying what looked like cheap corporate bonds, funding them overnight and buying protection through CDS. However, the apparent arbitrage was not a true riskless profit. Bonds looked cheap because of the cheapness of funding overnight and disappeared if one tried to fund to match the term of the CDS.  But what needs to be added to this observation is the fact that liquidity in CDS disappeared too!

The problem is that the potential length of the derivatives chains creates the illusion of liquidity. But the chains will fall apart when the anchors give way. Of course, derivatives will be more liquid that the underlying cash markets but the former will periodically be snapped back towards the latter by crises.


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