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Consequences Derivatives Market

Consequences Derivatives Market

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Published by: tofumaster on May 23, 2010
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rdodd@financialpolicy.org 1660 L Street, NW, Suite 1200 202.533.2588 Washington, D.C. 20036 
Consequences of LiberalizingDerivatives Markets
Randall Dodd
Financial Policy ForumWashington D.C.
September 2002, updated October 2003
I. Introduction
Derivatives are financial contracts whose price is
from that of an underlying itemsuch as a commodity, security, rate, index or event.
While derivatives markets have been inexistence for as long, and by many accounts even longer than that for securities, it has been their growth in the past 25 years that has made them one of the pillars of financial systems.
This istrue not only of developed, but also developing economies. Section II below will provide someindicators of the size and growth of derivatives markets in developing economies. Despite thetremendous growth in the size and use of derivatives markets, their role in economicdevelopment and their regulatory treatment have received far less attention than banking andsecurities markets from both the public and policy makers.In a manner consistent with this neglect, the push to liberalize capital market indeveloping countries in the 1990s showed no apparent concern for the potential dangers of unregulated derivatives markets. The need to address these dangers was most likely neglectedfor the following two reasons. One reason is that the push to liberalize financial markets focusedlargely on the elimination of controls, restrictions or taxes on capital flows, and this focuses on bank lending, securities issuances and trading, and foreign direct investment. This ignored thefact the trading in derivative instruments is often closely related to transactions involving thesecapital flows.
The second reason stems from the theoretical economic framework that served asthe foundation for capital market liberalization. This economic theory held that financialmarkets sufficiently disciplined themselves, and that they were more efficient than thosedistorted by government regulation. The theory concluded that the fewer, or the lower thedegree, of regulation the higher the degree of efficiency.In hindsight, this proved to be a costly error irrespective of whether it was due to anoversight or ideological over-confidence. If developing countries were imprudent to remove allcapital controls and deregulate their banking sectors, then they were even more reckless in their treatment of derivatives.In order to help rectify this omission in the future, this policy analysis will layout ananalysis of the public interest concerns with derivatives trading and markets in developingcountries and suggest a set of regulatory measure to reduce derivatives related financial sector vulnerability and to increase market efficiency.While derivatives performed the economically useful purpose of risk shifting (hedging)and price discovery,
they also created new risks that were potentially destabilizing for developing economies. The following is an analysis of how derivatives played a constructiverole in channeling capital from advanced capital markets to developing economies, and how at
) The term derivatives is used to mean financial instruments such as futures, forwards, swaps, options andstructured securities. For a more complete definition and description, see Dodd (2000a, 2000b).
) For an excellent history of derivatives see Swain (2000).
) See Dodd (2002b) for a discussion of how the use of derivatives can shape capital flows to developing countries.
) Price discovery, which will be treated below, refers to establishment of benchmark market prices that are usedmore broadly in the economy.
the same time they pose a danger to the stability of the financial system and the overalleconomies of developing countries.While derivatives play a positive role in the economy by providing enhanced pricediscovery and greater efficiency in risk shifting (e.g. hedging), they also pose potentiallynegative consequences. The potential problems with derivatives can be broken down into twocategories.The first category concerns issues that arise from the "abuse or misuse" or derivatives.This includes fraud, manipulation, tax evasion or avoidance and the distortion of information thatis vital for the efficiency of the market. The second category in pertains to the negativeconsequences from derivatives trading and derivatives markets. Whether or not derivatives areused or misused, improperly regulated derivatives markets can result in the creation of new risks,greater levels of market risk for a given amount of capital in the financial system, and in higher degrees of financial sector vulnerability. Section III below will address the many components of  both categories of problems related to derivatives markets.Taken together, these potential problems pose a substantial safety and soundnesschallenge to developing economies, and they therefore warrant immediate regulatory remedy.Towards this end, Section IV of this chapter concludes with a policy proposal that is designed tocurtail if not eliminate these problems while encouraging the use of derivatives for productive purposes.
II. Expanding the definition of "capital markets"
The usual definition of capital market liberalization, including both the policy principlesand their implementation, needs to be broadened so as to encompass derivatives markets andtheir impact on economic stability. Establishing the notion of derivatives markets as an integral part of financial markets will help address the concerns that the inadequate regulatory treatmentwas due to their being overlooked.A more complete view of capital markets is, by analogy, a four legged table made up of securities markets (issuing and trading bonds and equity shares), banking industry (issuing loansand providing payment and settlement services), insurance and pension funds (providing futureincome and collateral for lending) and derivatives markets (risk management and pricediscovery). All four legs serve to support the table, and it is no more stable than its weakest leg.It is perilous to focus exclusively on securities and banking even though that doesdescribe the largest share of developing country financial market activities in the past.Derivatives have been growing rapidly in scope and scale, and they have already assertedthemselves is financial crises.
Their presence was an important factor in Mexico, East Asia,Russia and Turkey.
) See Dodd (2002a), Garber (1998), Garber and Lal (1996) and Kregel (1998a, 1998b) for discussion of the role of derivatives in the Mexican and East Asian financial crises of the 1990s.

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