Wine. Cheese. Derivatives.

What do you think of when you think of derivatives?

At the PLSA conference in Liverpool last week we attempted to answer this question. We played a word association game with visitors to our (wine and cheese based) stand. We asked “What is the first word that comes into your head when we say each of these words: Wine? Cheese? Derivatives?”

The below gives an illustration of the responses we received:

word-association-2

One of the clear observations is that there is some overlap between all three.

Does “Crackers” mean Jacobs with respect to cheese or stupid (crazy/daft) with respect to derivatives?

Is “Wine” something you need with cheese or maybe something you need with derivatives?!

“Fun” is clearly associated with derivatives.

However, if we now isolate the responses that were elicited specifically by “derivatives”, the results are more telling:

word-association-2-cut

Aside from the observation that wine was the only word to transcend all three categories, I think this picture probably tells us what we already know – people find derivatives either complicated and/or scary.

The fact that “Swaps”, “Hedge” and “Bonds” appear shows some level of experience with or understanding of derivatives, and as a proportion of the total words I would guess this is actually a fair representation of the proportion of schemes using derivatives (the KPMG 2016 LDI Survey says there are about 1300 LDI mandates amongst the 6000-odd pension schemes).

I have written before on reducing complexity by using the analogy of an aircraft as something complex that people are generally fairly comfortable with. Our findings from the PLSA conference are a clear illustration that there is work to be done on making derivatives feel more accessible.

Whilst wine may have been the thing some respondents considered a solution to derivatives accessibility, there must be a better alternative to self-medication.

There are three aspects to accessibility:

  1. How derivatives meet scheme needs
  2. Mechanics of derivatives
  3. Documentation

I would argue that in situations where pension schemes are confused about the use of derivatives it is likely that they have focused only on numbers 2 and 3.

This is the key for me – derivatives are not an investment product that you buy off the shelf,  they are something tailored to meet a scheme’s needs.

So the first step should be to understand how, at a high level, they fit with what the scheme needs before thinking about your worries.

For example, continuing with the aircraft analogy the approach would be as follows:

  • I want to go on holiday
  • It is overseas
  • A plane can get me there
  • What are my worries?
    • Cost?
    • Crashes?
    • The maths?

I think a better approach to derivatives for pension schemes would be:

  • I have some risks I want to manage
  • Can derivatives manage these?
  • Broadly how do derivatives manage these?
  • What are my worries?
    • Cost?
    • Counterparty risk?
    • Nick Leeson?
    • The maths?

For some schemes it may well be that they do not see any risks that need managing, or that derivatives cannot manage those risks. All I would suggest though is to ask the basic questions first before reaching for the wine.

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