nottheaverageactuary

Actuarial news and views from Cape Town and beyond

Derivatives’ role in the financial crisis

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As much as the financial crisis was spurred by excessive risk taking and lending by banks, many market commentators also believe that derivatives making banks less transparent and bigger risk takers was also a root cause. A lot of this lack of transparency is due to the fact that there is an information asymmetry between the people who create these elaborate derivative contracts and the people who analyse them.

Since then, regulation has been put in place to try to mitigate potential risks that could result in another crisis and to try to ensure more transparency. One such regulation is the Dodd-Frank financial reform law instituted in the U.S. in 2010 that requires investors to set aside significant sums of cash to cover losses on their derivatives trades.

In practice, these margin requirements seem to make derivative trading less risky, however market players have already found ways around these requirements by, for example, a practice called the futurisation of swaps. Futures markets are less regulated and require lower margins and so traders are just packaging swaps as futures to make them more cost effective. This is just one example of traders getting around the regulations but there are likely to be many more.

This begs the question on how to realistically make these markets less risky. We know that there can be many benefits of derivatives for entities and so doing away with them is not an option (no pun intended), but maybe they need to be restricted to be purely vanilla in type?

Here are two articles by authors criticizing the use of derivatives:

http://www.forbes.com/sites/stevedenning/2013/01/08/five-years-after-the-financial-meltdown-the-water-is-still-full-of-big-sharks/

http://www.huffingtonpost.com/2013/02/14/wall-street-derivatives_n_2681610.html

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