THE huge forex derivatives losses suffered by SembCorp Marine (SembMarine) might remind some readers of investment guru Warren Buffett's famous warning that such complex instruments are financial weapons of mass destruction.
He also noted that such trades are "like hell - easy to enter and almost impossible to exit".
The objective of these instruments - anything from futures to options and swaps - is laudable. They were developed to let investors hedge their risks, providing a form of insurance against market movements.
A derivative allows an investor to gamble on the price of a foreign currency or a commodity without having to buy the underlying investment itself.
In recent years, they have been put to a myriad of uses. Some investment banks sell them to big companies such as SembMarine as a way to offload or manage market risks.
Sifting through the many choices
THE Singapore Exchange (SGX) is jumping into the act with plans to launch futures contracts on stocks traded in Singapore next year. It says such instruments will provide retail investors with "hedging and arbitraging opportunities".
Any Singaporean who has done National Service will attest that great care is needed around explosives. Get it wrong and they are likely to blow up, maiming or killing anyone in the vicinity.
As Mr Buffett observed, financial derivatives behave in very much the same way.
In September 1998, the global financial system was brought to the brink of collapse after US-based hedge fund Long-Term Capital Management (LTCM) defaulted on contracts believed to be worth US$1.25 trillion (S$1.82 trillion).
LTCM was not a fly-by-night operation run by a rogue trader. Its board included Nobellaureates in economics Myron Scholes and Robert Merton, who shared the 1997 award for their work in developing financial models used to price derivatives.
Granted, LTCM might have been an extreme case, but even in their less destructive forms, financial derivatives still have the power to push a company into a "spiral that can lead to a corporate meltdown" - to borrow another phrase from Mr Buffett.
That was exactly what happened to China Aviation Oil (CAO) here in 2004.
Its then-chief executive Chen Jiulin recounted in chilling detail how the company descended into hell in less than six months, brought down by oil trading derivatives that had gone spectacularly wrong.
Believing CAO could recover the small loss of US$5.8 million that it had incurred on oil trades in March 2004, Chen "doubled up" on his bets - a trading term for enlarging positions.
It is a misguided strategy that many remisiers have seen trading clients adopt to their peril.
As losses surged to US$30 million over the next three months, CAO continued to indulge in bigger and bigger gambles.
By October, it had made bets on 52 million barrels of oil - said to be enough to supply the fuel needs of all the world's airlines for six months.
It had, by then, used up all its resources to meet margin calls, as well as a US$108 million loan given by its parent from a share placement.
No tallying the loss till it's too late
HOWEVER, what was supposed to have been a "mark to market" loss of US$180 million on the contracts congealed into an actual loss of US$381 million as the company was forced to close some positions over the following two weeks.
When the final tally was in, after all positions were closed, it showed that CAO had lost US$550 million.
The trauma CAO went through was uncannily similar to the pain SembMarine must be suffering now.
Mistakes on such a colossal scale are not as isolated as some might think.
Last week, US investment bank Merrill Lynch shocked investors by increasing the write-down on its collateralised debt obligations (CDOs), pooling loans and bonds with different yields and maturities on sub-prime mortgages, to US$7.9 billion.
Experts will say that it is notoriously difficult to mark to market the true value of financial derivatives as they are complex and illiquid instruments.
In many cases, the profits and losses from such trades are booked straight away, even though no actual money changes hand. The real costs hit the companies trading them only when the positions are unwound.
This has left many traders wondering if the US$165 million (S$240.4 million) in unrealised losses announced by SembMarine due to unauthorised trades is too optimistic a figure.
SembMarine's estimated loss is based on the mark-to-market information for the forex transactions provided by the various banks.
It would be all too easy to be lulled into a false optimism and believe that the worst is over, that the event was just a one-off, so everyone can get back to business as usual.
But no one can be sure whether there are more surprises tucked away on SembMarine's balance sheet until the forex positions are closed.
Risky game for the unwary
SEMBMARINE?S experience certainly vindicates Mr Buffett's warning about the slippery slope that firms - or individuals - can find themselves on when they play with derivatives fire.
The case also raises concerns about whether SGX should push ahead with its plan to introduce futures trading on stocks next year for retail investors.
If Nobel prize winners and blue-chip companies can land themselves in a mire over derivatives, what morass might naive retail investors find themselves bogged down in?
For the bold trader who insists on navigating such treacherous courses, the only counsel that can be offered is caveat emptor (let the buyer beware).
More surprises in store?
Financial derivatives are hard to value. Many wonder if the US$165 million (S$240.4 million) in unrealised losses announced by SembMarine might be optimistic and if its balance sheet might hold more surprises.
