Derivatives, the financial crisis, and students

This Imperial College conference explained what happened and how the banking industry is changing as a result

Imperial College's New Financial Worlds conference is an annual event organised and hosted by the Imperial College Finance Society. It was only established a year ago, but is already a well-attended and popular day, attracting prominent industry figures as speakers and an audience of well-informed and lively students. The theme of this year's event, held at Bloomberg's London headquarters in March, was derivatives.

Why derivatives? They're complex and, some would say, arcane, and challenge even the brightest of financial minds. Yet in recent years they've also frequently hit the headlines in the mainstream press, thanks to the role that products such as credit default swaps and mortgage-backed securities played in the 2008/9 financial crisis. The conference addressed both sides of the double-edged derivatives sword: the financial world's capacity for innovation that these structured products represent, and their capacity to cause economic havoc.

The day started with some introductory perspectives. First, Ed Ground of J.P. Morgan explained how banks calculate and then use derivatives to manage the risks to which they're exposed through their trading activities. Then Greg Davies of Barclays Wealth took discussions in a contrasting direction, pointing out that the banking system's assumption that humans always behave as logically as mathematical models is misguided. Derivatives for him, then, are not just part of complex financial strategies but also, in their apparent risk-mitigating capacity, represent "emotional insurance" for those deciding where to put large sums of money.

Of course, the financial crisis showed that derivatives often functioned to increase rather than reduce risk within the banking system. Speakers certainly weren't afraid to engage with the question of what exactly went wrong from mid-2007, and to admit that serious errors of judgement were made by investment banks and other financial institutions. Andrew Kellner of Barclays Capital flagged up the rapid development of the credit default swap (CDS) market. These products were designed to protect lenders against the risk of borrowers failing to pay back debts, but developed into a way of speculating on the future financial performance of these borrowers. At the height of their popularity, the value of the CDS market far exceeded the value of the corporate debt market to which they were ostensibly attached which, as the financial crisis proved, massively increased market opacity and instability. The rapid evolution of CDSs and other derivative products also meant that senior people and parts of investment banks that did not directly deal with a particular type of derivative were dangerously unaware of their workings and implications. Investment banks, however, were not the only parties criticised - speakers during the day drew attention to how the demands of corporates for financial flexibility in a globalised market and continuous rises in profits in the short-term both also fed the rapid and ultimately destructive growth of the derivatives market.

Speakers also considered how the financial world has responded to the problems with the derivatives market exposed by the financial crisis. Paul Skinner of Goldman Sachs outlined new regulation, while Anu Munshi of B&B Structured Finance discussed the potential implications of the introduction of centralised trading systems.

So is now a good time for those attending the conference - and other students - to go into the finance world and work with these products? Overall, the speakers gave an impression of a sector undergoing dramatic and rapid change, but where neither derivatives, nor opportunities for bright graduates to work with them, will be going away.

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