Monday, October 20, 2008

Geopolitical Risk: Derivatives Markets without the Upside

There has been a lot of discussion about derivatives over the past few months, and for good reason. Derivatives--a broad class of complex financial instruments--include collateralized debt obligations (securitized-mortgages) and credit default swaps, which are right at the core of our current financial crisis. It's easy to get down on derivatives because when things go wrong, they can go terribly wrong (potentially much worse than we're currently seeing). But there's also an up-side to derivatives: they spread risk, allow parties to risk to effectively insure themselves, enable projects and ventures that would otherwise be untenable, etc. In this post, I want to compare and contrast the kinds of financial risk addressed by derivatives with geopolitical risk.

Defining geopolitical risk. Geopolitical consists of the following: the risk that the political or legal environment will change (e.g. nationalization, money transfer restrictions, etc.); the risk that the security environment will change (military coup, civil war, insurgency, etc.); the risk that the probability of either of these increase, thereby creating a positive-feedback loop that destabilizes the environment. That's all a fancy way of saying "all risk that isn't financial risk."

Can you insure against geopolitical risk? Yes. But there's a fundamental difference between insuring against financial risk and insuring against geopolitial risk. When we insure against financial risk, we make the whole system more stable (to a point, admittedly, and one we've been testing of late). Therefore, the more that people insure against financial risk--default, bankruptcy, etc.--the more stable the system becomes. This means that more insurance activity (more volume on the derivatives market) makes that insurance less expensive. Not so with geopolitical risk. You can essentially place a bet with one of a variety of geopolitical risk insurance providers that, say, your oil lease in Nigeria won't be reposessed, or that your employees in the Ogaden won't be kidnapped. But that activity of insurance doesn't make these events less likely to happen. Arguably, it actually makes them more probable (in the case of leasing, it commits more desirable and seizable infrastucture and resources to countries that might nationalize, for kidnapping it provides an alternative to investing in security services and ensures there's money via K&R insurance to pay ransoms).

In the end, this is because financial risk is spread through dillution, whereas geopolitical risk spreads through contagion. When we use derivatives to spread financial risk, we create both positive and negative effects. On the negative side, more parties are exposed to the risk, creating a higher degree of interdependency. A potential shock is no longer contained, but rather spreads to all involved parties. However, on the positive side, the speading of financial risk also dilutes that risk (you can argue this is undone by simultaneously facilitating yet more leverage, but up to a point this is still a good thing). That isnt' true of geopolitical risk. With geopolitical risk, hedging against geopolitical risk doesn't dilute the risk at all--it just shifts it from the insured to the insurer. And, because the shield of insurance facilitates increased involvement in geopolitically risky regions, the net effect is actually to increase interconnectedness. Geopolitical risk can't be diluted (only redistributed), and hedging against it actually makes the shock waves travel further.

Why these differences are important, especially to energy supply. It is critically important to understand this difference between financial risk (and associated markets) and geopolitical risk (and associated markets), especially when it comes to understanding our energy future. Right now, high energy prices create an incentive to explore and produce energy resources everywhere--including the most geopolitically riskly locales. Normally, the geopolitical risk would make many such areas financially inaccessible. However, with inaccurately priced means to hedge geopolitical risk (both through pure geopolitical risk derivatives and through various other vehicles such as long-term futures contracts, tax deductions, etc.), all comers are wading waist-deep into the fast running waters of Nigeria, Angola, Sudan, Ethiopia, Khazakstan, Bolivia, and elsewhere. As a result, we're maintaining global energy production and facilitating our ongoing profligate consumption of these resources while dramatically increasing our exposure to geopolitical risk. In part because of the positive feedback-loop nature of this risk (see my brief on the topic), this creates a self-fulfilling prophecy of geopolitical supply shock. And here, just like with the credit markets, the longer it takes for this shock to materialize, the more severe it will be.

At the end of the day, while financial derivatives markets are a key component of our current financial mess, they are a truly powerful tool that can be used for great long-term good if regulated (with an understanding of long-term systemic risk issues) to ensure they are not abused for short term profit. Derivatives markets that address geopolitical risk, on the other hand, only delay an inevitable accounting for the underlying causes of the risk--rather than diluting risk they merely facilitate increased exposure to that risk. When this incrased exposure is combined with the geopolitical positive feedback loops that I've discussed previously, it is a recipe for disaster. In particular, because the "force of nature" character of geopolitical positive feedback loops is not well understood, geopolitical derivatives tend to be priced incredibly inaccurately, ensuring that the future geopolitical situation comes as a severe shock.


Anonymous said...

Do derivatives and risk spreading realy stabilise a system? To me it seems that they actually reduce resiliance and long term stability by exposing everyone to the same amount of the same kind of risks.

Global risk spreading has ensured that if we go down we all go down together, which seems to be the least resiliant alternative. More localised risk would produce a more staggered collapse, allowing room for diverse solutions that can evolve and build on each others succeses.

Also, what about the feedback loops caused by global dilution of risk, did they tend towards encouraging more or less risk taking?


Jeff Vail said...

Derivatives do stabilize a system to the extent that people who can't absorb a given shock disribute that shock to those who CAN. The problem we're currently experiencing is that, because firms assumed they would never have to actually absorb these shocks, they took on more risk than they could actually absorb. So, bottom line, the moderate and conservative use of derivatives does increase systemic resiliency, but in the absence of regulation (or foresight and wisdom) this can quickly tip into increasing instability. Which, in the end, comes back to the Problem of Growth...

sv koho said...

Fair enough Jeff. Derivatives are insurance against risk but if the insurance company or party defaults, you got nada. The BIS has a decent accounting of world derivative exposure and the figures appear ludicrous: something north of 660 TRILLION dollars last time I looked. That is about 10 or 12 times World GDP. A huge percentage are currency, commodity and interest rate derivatives but the others are there although it's a slog to get through the site. Insurance is only as good as loss reserves on hand. Of course to pay off the loss you could print $600 trillion. Then what?

adamf said...


Not sure if you answered Anonymous's points entirely.

A system which suffers from many small to serious breakdowns will be less likely to suffer an all-consuming collapse. Without regular stresses, systems lose redundancy, grow very efficient in perfect conditions but fragile. The spreading of risk through derivatives which reduces smaller crises, may actually increase the possibility of full systemic failure. What is hedging for an individual ultimately equals putting all the eggs in one basket for the system, since when that shared-risk turns out to be a losing bet everyone goes down together.

If you haven't seen it yet this Oil Drum article from a couple of days ago addresses this very issue, the metaphor of the sand piles is pretty useful I thought:

The Failure of Networked Systems: The Repercussions of Systematic Risk

Yrs, Adam in Melbourne, Au

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