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14 Int'l Fin. L. Rev. 28 (1995)
How to Recognize a Derivative

handle is hein.journals/intfinr14 and id is 276 raw text is: Howto recognize a derivative In the first of a new series on derivatives, Claude Brown of Linklaters & Paines, London, looks at the problem of defining derivatives and what instruments fall within the definition. Deciding whether a financial instrument is or is not a derivative is rather like the so-called Elephant Test -they are hard to describe but you knowwhen one has sat on you (a view with which several banks may concur). Some might also be inclined to add that, like elephants, deriva- tives (and their keepers) are expensive to keep and are best returned to the wild where they belong. Others argue that derivatives are already too wild and need taming or should be hunted to extinction. Definitions The problem of deciding which products should be categorized as derivatives has given rise to much debate. Usually the debate has centred on definitions. With derivatives, the basic definition is generally not in dispute. It is agreeing what the definition covers that is the contentious part. To take the Group of Thirty's definition as an example, it begins with wording few would challenge: In the most general terms, a derivatives trans- action is a bilateral contract or payments exchange agreement whose value derives, as its name implies, from the value of an underlying asset or underlying reference rate or index. Today, derivatives transactions cover a broad range of 'underlyings' interest rates, exchange rates, commodities, equities and other indices. It then goes on to include products traded on exchanges: In addition to privately negotiated, global transactions, derivatives also include standardized futures and options on futures that are actively traded on organized exchanges, and securities such as call warrants. Here, some of the players in the exchange-based markets may start to mutter. Exchange-traded products have been around for several hundred years. Their traders find now being told that they are all 'derivatives' hard to swallow. But the fat really hits the fire in the third part of the definition: The term 'derivative' also is used by some observers to refer to a wide variety of debt instru- ments that have payoff characteristics reflecting embedded derivatives, or have option character- istics, or are created by 'stripping' particular components of other instruments such as principal or interest payments. This is the nub of the Great Derivatives Definitional Debate - should this third category properly be considered as part of the extended family of derivatives? Those who argue for their inclusion (to remain with the zoological metaphor) cite the Duck Test - if it looks like a duck and sounds like a duck, then it probably is a duck. Therefore, they claim, it is misleading (and poten- tially dangerous) to treat these things as anything other than derivatives. Although it is true that many derivatives derive their value from their underlying asset(s), it is also true that, at certain times in particular markets, the price or value of the underlyings derives from their related derivative. An example of this phenomenon is where trading in futures contracts over an index of shares affects the value of the shares comprised in that index without the shares themselves being traded. This poses the question: which product is the underlying and which is the derivative? The legal attributes of derivatives Side-stepping such metaphysical issues, the derivatives lawyer has to face another classification-related question: what legal attributes do derivatives have in common, not only with each other but also with other financial instruments? Derivatives have four major common legal attributes. This is not to say that any of these attributes are unique to derivatives, nor that there are not other attributes that may also be relevant. However, each of these four attributes needs consideration when analyzing any derivative in a legal context. Agreement All derivatives involve some form of agreement between the parties involved. This may be stating the obvious, but there are an awful lot of litigators who eke out a meagre living from agreements where the obvious was forgotten. Whether the agreement falls to be considered under civil law or common law principles, there are some questions which are common to both systems. When is the agreement made? Is it binding? How is it evidenced? Must all the terms be expressly set down? As a matter of law, can the parties enter into the agreement? For the derivatives lawyer, all that time at law school spent preparing those lists of the principles of contract law when revising for the exams now pays off. When approaching any derivatives contract, a quick run through that checklist (Is there an agreement? Consideration? Contractual intention? Form? International Financial Law Review 28IMay 1995