MIDDLE EAST TECHNICAL UNIVERSITY DEPARTMENT OF ECONOMICS

ECON 400 Fall 2012 FINANCIAL DERIVATIVES: THE ROLE IN THE GLOBAL FINANCIAL CRISIS AND ENSUING FINANCIAL REFORMS

Submitted To: Assist. Prof. Dr. Hasan Cmert

Submitted By: Taha Santalu

1723436

January 06, 2013

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Financial derivatives: The role in the global financial crisis and ensuing financial reforms

Abstract Financial derivatives trading has massively increased in the recent years and this upsurge in their use has paved the way for the recent global financial crisis. Their characteristics, which has enabled them to be used almost anywhere, has played a role in this upsurge. Among the derivatives, OTC derivatives are off- balance sheet items which have rendered the financial world a rather obscure place. They have caused the risk accumulated in the system be unknown so accumulating a huge systemic risk and have made the pricing almost impossible. Besides, the interconnectedness in the financial system has made it possible the spreading of one partys risk to other parties which is called the contagion risk. These problems paved the way for the recent global financial crisis and subsequently major countries started to revise their financial industries in order to halt this merry-go-round and not to let a likewise disaster occur in the future. Although it is rather difficult to prepare a policy that can satisfy everyone in the industry considering the huge number of the players, the regulations both in the US and the EU try to address the problems that arose due to skimpy regulation.

Taha Santalu Department of Economics Middle East Technical University Ankara, Turkey Email: e172343@metu.edu.tr

INTRODUCTION

Derivatives have been very important tools for hedging and speculation purposes. They have been massively used in order to keep safe from volatilities and thus decrease business risk and sometimes for profitable ends. However, due to the lack of financial regulations and greediness of financial institutions they have been a part of the abusive practices of the industry. The amount of OTC derivatives traded today is around ten times the global annual GDP and the transactions between parties are very opaque. Prior to the financial crisis this caused an enormous risk to accumulate in the financial industry unknown to anyone and no one was aware of the magnitude of the risk that this situation posed for the financial markets. Interconnectedness between the financial institutions made the spread of a crisis very easy. As the share of derivatives was massively large in the market, it was virtually impossible to measure the health of financial firms, either. So, not knowing the risks caused many players to require higher amounts of collaterals which prepared the downfall of AIG, or otherwise threatening to redeem their positions and withdraw from markets causing the liquidity to dry up. This financial disaster in 2008 spurred policy makers to revise the regulations and a G20 summit drew a road map for all the countries to follow. The summit basically suggested improving transparency in the derivative markets, mitigating systemic risk and protecting people against market abuse.8 In accordance with the summit, OTC derivatives have to be standardized and be brought to an exchange, whereby, the complexity of derivatives will be minimised and all the transactions that take place between counterparties will be known to everyone. This will render possible alleviating the opacity in the market and thus increasing market transparency. Besides, these transactions have to be cleared through a certain third counterparty known as a clearing house that will lessen the counterparty credit risk and mitigate the systemic risk. Whats more, trade repositories will be adopted for reporting purposes in order to increase market information. The US and the EU too took major steps in this direction in line with the summit preparing the Dodd-Frank Act and EMIR, respectively. This paper starts with an analysis of derivative types. Subsequently, it takes stock of role that derivatives played in the financial crisis and continues with reforms and regulations proposed and their implications, advantages and drawbacks. It goes on with the regulatory changes in the financial industry in the US and the EU with their possible effects.
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WHAT ARE FINANCIAL DERIVATIVES? Financial derivatives are some price or performance guarantees depending on what type of derivatives they are. They are utilized mainly either to decrease an uncertainty in the future or to profit from a deal which one side thinks that he could wager on it if the market behaved as he anticipates. Price guaranteeing derivatives date back to several decades and they include stock, currency and interest rate derivatives which bring two sides to a deal for locking in a price. Doing that, a future price is determined in advance and exposure to market volatilities is diminished which keeps the counterparties safe from risks. This means that some of these derivatives are not only good for risk-aversing but also can be employed to pocket handsome profits through speculating, which we will touch upon shortly. Other derivative types are credit derivatives which act like performance guarantees that are believed to be the main perpetrator of the global financial crisis and weather derivatives that vouch for weather conditions. However, it should be kept in mind that price guaranteeing derivatives form the vast majority of derivatives. The reason that they are called derivatives is that the value of this financial instrument derives from the current market price (spot price) of another financial instrument or commodity which is named as underlier. Almost anything that can be traded can be employed as an underlier. However, according to Durbin (2011), those that usually come in handy are the ones that are fungible (one is as good as another) and liquid. Those that meet this criteria can be listed as commodities, currency, money and equities. Furthermore, there are some indexes (the weighted average of some predetermined stock prices) that are used as underliers. Since the indexes cannot be bought and sold, in the end of the event it is required that a cash settlement is done between the parties. There are two sides to this kind of agreement and they are called counterparties. Depending on the spot price of the underlier one of these parties gains and the other party loses, essentially making these types of derivatives a zero-sum game, because for every penny gained by the winner side, there is the other party with the offsetting loss. There are four basic types of derivatives which constitute as pillars of the derivative markets and their variations or combinations form the complicated elements of the derivatives. They are: Forwards: In this contract the buyer agrees to buy the underlier in a specific date in the future for a specific and predetermined price. They are traded at
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OTC (over the counter) markets where the trade takes place directly between the two parties. Futures: They are specialized forms of forwards that are traded not at an OTC market but at exchange markets, through which there remains virtually no possibility of breaching the agreement so that both parties will fulfill their obligation. Swap: Swaps are about future cash flows. In this agreement both parties exchange their swap conditions whereby they practically assume the other partys obligations. They are traded at OTC markets. Option: Options are a little bit different than the preceding trio. They are not burdening the buyer with an obligation, rather, they grant him an option either to buy or sell the underlier at the specified price, either on or before the specified date, depending on the type of the option in hand (American or European). A vast majority of options are traded at exchange markets.

There are some differences between the markets that these derivatives are traded at. The existing markets are OTC and exchange markets. At an OTC market, the buyer and seller must find each other and the terms of the agreement are shaped according to the exact needs of both parties. Thats why, OTC traded derivatives are specific to the parties. On the other hand, at an exchange market, there are market makers who define and word the details of the derivatives and buys or sells them, depending on the counterparty. This provides the market liquidity and thereby, it is very easy for the exchange-traded derivatives to be bought and sold instantly compared to the OTCs. Whats more, in an OTC market it is not guaranteed that the counterparties will fulfill their obligations. When the tides move against him, a forward buyer might have a penchant not to buy the underlier at the specified date and thus escape his responsibility. However, the exchange markets do not have this risk as the exchange itself guarantees the fulfillment of responsibilities by both sides through margin accounts or daily marking to market. As explained before, derivatives are mainly used for two things: Hedging and speculation. Let us think of a Turkish trader who envisages that due to a war looming on the horizon, the value of Turkish Lira will be very unpredictable and volatile. This in mind, he fears that this will adversely affect his business and he decides to make an agreement with
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another party. According to the agreement, six months from now, he will buy dollars from the other party for todays value which is 1.79 TL, a lower value than the future spot rate which is more than 1.79 TL. In this manner, the trader wants to protect himself against an upward movement in the price of the dollar and tries to manage the uncertainty. As for the speculation, the speculator uses derivatives leverage power. Speculators can speculate without derivatives as well. However, leverage grants them the possibility to put less money in an investment and earn a lot. For example, instead of buying stocks of a company that you think that will increase in the future (bullish), you can buy the options of these stocks thus putting less money than the price of the stocks, because a stock option is much cheaper than the stock price itself. Yet, it is not all rosy with the leverages either, because leverages come with an increased downside risk that when your expectations of the stock price increasing does not come true, then you lose 100 percent of your investment which is the subscription price paid for the option. On the other hand, if you had invested in the stocks, then you would have lost only a percentage of the stocks and still be owning the stocks. There are also market makers and arbitrageurs who have a role in the derivatives market. Market makers are those that make the rules in an exchange market thus, mainly behaving as a dealer, making money out of intermediary actions and providing liquidity to the market through acting as a seller to the buyers and as a buyer to the sellers. Arbitrageurs are the ones who are the wily foxes of the market. They search for the mispriced securities and snatch them as soon as they see one. There is no risk at all at what they do, however as the markets became more efficient and the computer systems smarter, the role of the arbitrageurs in the market has waned considerably. The Forward Contract In this contract the buyer agrees to buy the underlier in a specific date in the future at a specific and predetermined price. The buyer in this agreement is the long party while the seller is the short party. Forwards are the most rudimentary form of the derivatives and they are used to decrease the uncertainty involved in a business. If we sign a forward contract with a wheat seller, to buy 10 tons of wheat after six months at a price of 2$/kg and after six months the price of wheat becomes 3$/kg, then the contract has a 10000$ value for us and 10000$ loss for the wheat seller. Thanks to this contract, we locked in the price and kept ourselves safe from the uncertainties that could cost us 10000$ in six months. This is a basic example of forwards. While one party gains an amount, the counterparty loses exactly the
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same offsetting amount, rendering a forward contract a zero-sum game. The most prevalent forward types are FX forwards, commodity forwards - oil and natural gas primarily- and money forwards where one party locks in a predetermined interest rate to borrow money to avoid wild fluctuations in the interest rate. In the delivery date of a forward contract, parties are obligated to buy and sell, namely fulfill their responsibilities. However, if they find themselves in a financially dire strait, they might choose not to buy or sell, thereby breaching the agreement. This constitutes as a credit risk and not to confront this, parties are inclined to keep some collaterals from the opposite party. The payoff of a forward contract can be expressed as: PFwd,Long = S-K (S= Spot rate and K= delivery price) PFwd,Short = K-S These formulas make it clear that one sides gain is equal to the other sides loss.

The Futures Contract This type of contract has many things in common with forwards contract. The main difference comes from that futures are traded at an exchange market while forwards are traded at OTC markets. Even the pricing methods for the both are almost the same. As a result of being traded at an exchange, parties do not have to find each other, since there is a market maker who provides liquidity. This market maker also sets the contracts and the prospective counterparty cannot change anything related to these contracts. It is take-it-or-leave-it. Now, the most important difference is the daily marking to market feature which takes away the credit-risk that is inherent in a forwards contract. This means that, at every end of the day parties make payments to each other and the following day the value of the contract becomes zero with the same terms. As futures are more liquid than forwards, this does not signify that all the futures are as liquid as another one. There are some futures that are having a high volume of trading at market, some of them are not like this. This means that there is some liquidity risk at futures contracts, due to which it may not be possible to sell or buy a contract at desired prices.

The Swap Contract A swap contract is used to exchange the future cash flows. Swaps are traded at an OTC market which make them likely to be defaulted on by the counterparty. The most important swap types are fixed-floating rate swaps (plain vanilla) and currency swaps although they can be employed in many other areas. In both types the aim is to remove interest rate uncertainties. The counterparties want to change their own obligation with the other partys, so that they think this would suit them better due to commercial needs or comparative advantages. In a fixed-floating swap agreement there is one fixed leg, which pays the fixed rate, and one floating rate which pays according to the fluctuations of the market interest rate. The one who pays fixed is long and the other is short party. For instance A has a 10000$ loan with a fixed interest rate of 5% payment every three months, and B has a 10000$ loan with LIBOR rate payments every three months. A thinks that it is better for him to pay floating rate interest than the fixed and B thinks it would be better to be able to know what he would pay in the coming months in order to shun interest rate fluctuations. So they agree to swap their conditions, practically A taking up Bs obligation and B taking up As. The 10000$ here is named the notional and does not need to change hands in the end of every term. Only the difference between payments changes hands between parties and that is it. As this agreement is reached, then A no longer worries about the fixed rate, and B no longer is concerned about the fluctuations in LIBOR. Swaps have a very huge market so that although they are traded at OTC market, actually they do not face liquidity problems a lot and it is almost always possible to find a swap dealer to make a swap. The reason that parties apply to swapping their interest rate types, for example from floater to fixed, and not taking a fixed interest rate in the first place instead of a floating one, can be due to the fact that normally fixed interest rates are more expensive than floatings. It is because their present value is greater. Besides, taking a fixed rate much depends on the creditworthiness of the loan-taker, so that if the credibility of the loan taker is not that high, then he takes up a floater and then swaps it to a fixed rate. The only swaps type where the notionals change hands is the currency swaps. In currency swaps, where counterparties hold different type of currencies, parties, in the beginning and in the end of the swap, exchange notionals in order to get rid of the fluctuations in the exchange rates, because the aim of a swap is to eliminate interest rate fluctuations.

In the aforementioned example, parties made payments to each other at every three months (tenor=3 months). However, there is no such necessity that parties make payments in the same frequency. The Option Contract In the preceding three derivative types, the parties were obligated to buy or sell the underlier, yet here, an option grants its holder the right, but not obligation to buy or sell the underlier. If the holder has a call option, then he has the right to buy the underlier from the seller (writer), and if he has a put option, then he has the right to sell the underlier before or on the specified date. (Note: if it is an American option then the holder can exercise it before the expiration; however, if it is a European option, then it can be exercised solely at the expiration date). Options come with a price too, the writer of the option receives some premium from the holder of the option based on the value of the option. This is another distinguishing feature of options from the preceding derivatives which come free of charge. Lets suppose that Abigail has a call option with a strike price 15$ on a stock that is trading at 20$. Assuming that it is an American option, she can buy this stock right now for 15$ instead of its spot price which is 20$, thus making a profit of 5$. If she had a put option with a strike price 15$ on that same stock and the stock traded at 20$ again. Then she could sell the stock for 20$ for its market value instead of using the option and selling it for 15$. This means that she simply leaves the option to expire and the amount of the premium she had paid for goes down the drain. If the price path of a call option is analyzed, when the option trades at a price higher than its strike price than it is said that the option is in the money. If it trades at the exactly same price as the strike price, then it is said to be at the money and if trades at some price lower than the strike price then it is said to be out of the money. Most options are traded at exchange markets The option payoff can be summarized under these formulas: PCall,Long =max(0,S-K) PCall,Short =min(0,K-S) (S= Spot rate and K= delivery price) PPut,Long =max(0-K-S) PPut,Short =min(0,S-K)

When we show the payoff formulas in that way, actually we overlook the effect of the premium that is paid beforehand to the writer. This premium will increase the payoff the short party and decrease the payoff of the long party.
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Options are good tools to both speculate and hedging. As in the example given, if it is forecast that in the future the price of a stock or a financial instrument will increase, or it is believed that it is undervalued now, then buying a call option can result in a handsome profit for the speculator. However, if her predictions are wrong then she will face a 100% loss. As for hedging, if the value of the underlier in hand is not desired to fall below a specific price, then some protective puts can be employed through buying put options. When the value goes below the undesired level then the put option can be exercised, whereby the holder will be compensated for the market decline. This shows that protective puts may come in very handy when stocks are at record highs and if the premium prices do not offset the gains, they can be employed as insurances against market declines. The hedging here and with other derivatives also, works like this: If the position held in the underlier is long position, then the reverse position which is short position must be held at the derivatives as a hedge. Therefore, when the underlier does not perform good, then the opposite position (derivatives position) will perform good, thus offsetting the detriment that would be suffered due to the bad performance of the underlier. This means that the the hedge position that is kept should be perfectly negatively correlated to the first position.

Credit Derivatives Credit derivatives, unlike other derivatives are performance guarantees but not price guarantees. They are traded at OTC markets and are believed to have a major role in the 2008 financial crisis. Most important ones are credit default swaps, and the others are total return swaps and credit linked notes. Their value is determined by the underlier, however compensation takes place only if a credit event occurs, otherwise the sellers of credit derivatives do not make any payment. Seeing this, they can be considered like some credit insurances. They are important because they render it possible to decompose overall risk into market risk and credit risk in order to deal with them on their own. Since all the financial instruments carry a default risk, these derivatives are important for diminishing the investors direct exposure to defaults.

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Credit Default Swaps Credit default swaps (CDS), are the most important credit derivatives. In a CDS there are three parties. There is one protection seller which is a financial institution or an insurance company, one protection buyer and a reference entity which issues the debt securities that the protection buyer owns. The protection buyer makes an agreement with the protection seller that if the reference entity suffers as a result of a credit event, the buyer will be compensated in return for an annual premium or CDS spread. The reference entitys creditworthiness determines the premium amount or the CDS spread. The reference entity can be a corporation that issues securities or a state that issues its government debt. Since the beginning of the 2000s onwards, lending standards had fallen comparatively and the credit history of the credit taker became not to be investigated necessarily. This situation was visible especially at mortgages where subprime borrowers, who are more likely to default on the debt, had an easy access to credits. Some people who saw that and forecast that more of these subprime borrowers could not pay their debts and would default, put some bets on the CDSs that were written by some financial institutions. Since these CDSs are OTC market products and not traded at regulated exchange markets, they lacked the necessary supervision and these institutions themselves presumed these bets to be very safe bets that would not payoff. So, they were very happy to collect the premiums from these bets and did not take necessary precautions and did not keep enough capital against a credit event. Rating agencies were convinced that mortgage-backed bonds, even the subprime ones, were sufficiently diversified that default rates of the subprimes would be uncorrelated, meaning that one subprime borrowers default would not trigger some others. This meant that they too had overlooked the possibility of a major thing that could hit the market entirely, causing defaults at enormous rates. The lending was rampant and the house prices had skyrocketed which was a bubble and would burst in the end. Those people (speculators) who made bets, made their bets on exactly on these mortgage-based bonds with CDSs. They thought that these bonds were overpriced and and if they shorted them when the prices fell, they would profit from it. That is exactly what occurred in the end. CDS sellers had not taken necessary precautions and did not have the capital to pay to the betters so they had to be bailed out, as in the AIG example. The same thing happened with the collateralized debt obligations as well. This proved that, financial derivatives had a role in the global financial crisis.

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LEADING TO THE CRISIS As it was expressed above, derivatives had a massive share in the outbreak of the global financial crisis. These villains of the finance industry, once famously called as financial weapons of mass destructions have become omnipresent in the financial industry, with their tradings reaching unbelievable amounts. The derivatives market today is one of the biggest markets in the world with a notional amount outstanding only in OTC market in December 2011 around $647.762 trillion. OTC derivatives comprise %96.6 of total derivatives and the remaining is in exchange traded derivatives. To have a better understanding of the numbers, it has to be stated that it is about ten times the global annual economic output (Bank of International Settlements, 2011).

Although the advent of the global financial crisis was not predicted by many people, the then-current situation before the crisis was calling for a serious consideration of the changes that the financial system and markets had undergone. Markets were replete with complex financial products which were exempt from regulation. The banks providing these products were euphorical for profiting handsomely on them, therefore they did not care much about serious implications and consequences of their negligent risk management. Predatory lending was at ease and the whole system was at the curse of the leverage factor that could bring down all the system quickly. In hindsight, all these factors were calling for a doomsday that was glaring. In essence, the main responsibility fell on credit derivatives which were put to use en masse and according to Gibson (2007) were carrying many risks such as credit risk, counterparty risk, model risk, rating agency risk, and settlement risk. The notional amount of
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credit derivatives multiplied within a very short time and reached to $36 trillion by 2006 according to the figure by ISDA. After the crisis struck, some terms like CDOs and CDSs left the vernacular of Wall Street and and gained a firm foothold in the everyday language.

Those credit derivatives that were being traded most at these years were Credit derivatives and Collateralized Debt Obligations. Firstly, Credit Default Swaps (CDS) alongside the housing and mortgage markets played a crucial role in the financial crisis. They were extensively used as insurances without putting up sufficient reserves for the unexpected events and their extent went beyond their objective. They had been started to be traded in the mid-90s and in the beginning they were intended to be used to effectively transfer the credit risk, in other words, they were invented for hedging purposes. There would be one insurance buyer and one insurance seller who generally knew each other, so that the insurance buyer knew actually who stood behind the insurance. As time went by, the CDSs started to be utilized as a means to make money and turned out to be a tool for investment which before the crisis were the fastest growing financial derivatives type. An over the counter (OTC) market grew and due to the opaque nature of the market, the transactions became less transparent between parties. Large amounts of risk grew unknown to the regulators and no one was aware of the magnitude of the risk that this situation posed for the financial markets. One of the
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tricky gifts that CDSs granted to the market was that it was not obligatory to own anything here. Anyone was able to put a bet on the debt of a third party with an insurer and this reached to such a massive dimension that, according to the CNN Money1, the CDS market went from $919 billion in 2001 to $62.2 trillion in 2008 second quarter right before the crisis broke out.

Some CDSs were employed in order to insure risky mortgages and since they were being written as if nothing bad would ever happened, the premium grabbed from writing them lured the writers to behave recklessly. This led the amounts to skyrocket, though they did not have the necessary capital to prop it up since they spent all the premiums on the contracts on other tradings. Michael Greenberger1 maybe explained their role best: "If CDS had been taken out of play, companies would have said, 'I cannot get this [risk] off my books, If they could not keep passing the risk down the line, those guys would have been stopped in their tracks. The ultimate assurance for issuing all this stuff was 'It's insured. CDSs played a role in the fall of some major financial companies like Bear Stearns, Merrill Lynch and AIG as if to show how interconnected the financial system was. All were interconnected to one another by CDSs and some other derivatives. Considering the nature of the Credit Default Swaps, essentially they
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are a different kind of gamble that people play, only with more far-reaching outcomes considering that it was the tax-payers money that saved the AIG. However, the game is unregulated due to te OTC markets and it is not for sure that the house would honor its debt. As a matter of fact, it is possible that the identity of the house be unknown. These bets are transferrable to the third parties, and once one thinks that his counterparty is some entity he knows, it can turn out that, the other side of the bet be someone quite different. This is exactly what creates the counterparty risk. At that time AIG held a CDS portfolio of $400 billions in notional value whose real value could not be determined due to the fact that there was no real market to fairly price the said contracts. The downfall of AIG, if not thwarted by the government, would mark the radiation of a collossal wave of repercussions towards the global market since many banks, hedge funds, corporations and many kinds of investment institutions were in its derivatives network. Although these mentioned institutions were independent financial institutions, the interconnectedness between them would cause the crisis to spread faster and induce a greater detriment in the financial world as if that were not enough. According to the Reuters2, AIG went through an $18 billion loss in the first three quarters of 2008 due to the mortgage-linked derivatives guarantees that it underwrote. As the home-owners started to default, things began to go bad and and the credit ratings of the company fell. (Standard&Poors, Fitch and Moodys all together). This required the company to put up extra collateral for the insurances that it underwrote in accordance with the policies it had written. This meant that the company had to come up with a $85 billion amount of money that it did not have and could not raise. This resulted in the bailout of the AIG. Bear Stearns case is another appalling case that requires scrutiny and this debacle also has a lot to do with derivatives especially some fancy ones that are called Collateralized Debt Obligations (CDOs). CDOs are like the second generation of mortgage backed bonds. Mortgage backed bonds are like a pool of mortgages that classified the mortgages with a rating starting from triple-A down to triple-B and then distributed dividends accordingly. The triple-A bondholders bore the lowest risk yet, at the same time had the lowest yield and the triple-B bondholders enjoyed the highest yield but bore the highest risk as well. In this scheme, if there happened to be any mortgage defaults, then starting from the triple-Bs, bondholders will not get their full interest payments and depending on the magnitude of the defaults this might lead to no payment at all. The big thing with this was that the credit
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lending was so much at ease at that time in the US that there were many people who in fact could not pay back their mortgage loans. However, lenders did not make this much of their concerns, because they thought that the housing prices were appreciating very fast and had never seen a fall in the last eighty years (Dodd & Mills, 2008). This would make the underlying houses good collaterals and the increase in their values would make it up to any repayment problems. These subprime borrowers were mixed into this pool as well. While even instantly this might sound really perilious for the whole system, the credit agencies thought that the subprimes were diversified enough and would not pose any risk for the system and the overall default rates for pools would not be exceeding the historical default rates. What they did not take into account, as it was expressed before, was that they could not foresee a major hit that could shake the whole market. This giant pool could have a second round in which some triple-B (subprime) mortgages could be brought together and be classified as if it was the first round and rating them all over again. All these subprime mortgages, when put into the pools in the first place, would not be profitable for bond dealers for the ratings they held, so dealers thought of the second round and pooled them among themselves to create triple-A ratings out of triple-Bs. So, they would be able to sell them for a higher price because now they carried triple-A ratings unlike before when they carried triple-B ratings. Simply nothing but alchemy. According to the Financial Times4, the mortgage-backed CDOs market had grown by $131 billion only in 2006 and it was swamped with opacity, illiquidity and shady valuation. This alchemy was too much a protagonist in Bear Stearns episode. In the middle of 2007, when the first signals of the housing collapse came, Bear Stearns was holding significant amount of CDO contracts. It was so difficult to value these complex derivatives that, in one of the statements made by the company itself 5, it was told that they could not figure out the amount of the loss they had. These complex derivatives would not be markedto-market in order to determine the value change in them. In order to understand the real value of them the underlying cash flow had to be investigated. The price discovery became a major problem that financial institutions faced and it made for them rather painful to meet the requirements regarding the value disclosure of these derivatives and derivative-based assets. This ambiguity in the value disclosure made it even vaguer for the investors how valuable their investments were and the real exposure that their investments had. This showed that the opacity itself was a big threat for the financial system. As the share of derivatives was massively large in the market, it was virtually impossible to measure the health of financial firms. As this was the case, it became a common behaviour to request more collateral from
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financial parties (as it was the case with the AIG) or threatening them to take their business elsewhere. So, not knowing the risks caused many players to redeem their positions and withdraw from markets. This was alerting a liquidity dryup. Trading almost ceased and liquidity dried. This meant that investors or insufficiently capitalized hedge-funds could not change their losing positions since there were no market makers and highly leveraged positions (through derivatives) were doomed for being overly exposed to price fluctuations. New York FED president William Dudley likened this situation to a modern day bank run for the reason that the market liquidity severely went down. Forbes6 reports that according to the Federal Deposit Insurance Corporation, US banks held $250 trillion derivative instruments which was 150 times their aggregate balance sheet equities. This incredible level of leverage displays well how these instruments effect on the system could be huge. All in all, for the fact that credit derivatives are OTC market products and there is no designated market maker, right at the time when liquidity needed, when the highly leveraged investors had to abandon their losing positions, there was no liquidity. REFORMS AND REGULATIONS As the financial crisis laid bare the massively built risk by the OTC derivatives in the financial markets, reforms over the derivatives market were started to be negotiated all over the world with the United States and the European Union being centers. The problems, shortcomings and deficiencies emanating from derivatives were tried to be reviewed and then addressed with the objective of solving the derivative-related problems once and for all and not going through the same financial calamities yet again. As a first step in this direction, in 2009 the G20 summit gathered at Pittsburgh in order to curb the merry-go-round of OTC derivatives. There they decided to standardize them, have them cleared through central counterparties (CCPs), bring them to exchange markets and mandate reporting them to trade repositories. The outcome of the meeting was summarized as following: All standardised OTC derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by end-2012 at the latest. OTC derivative contracts should be reported to trade repositories. Noncentrally cleared contracts should be subject to higher capital requirements. We ask the FSB and its relevant members to assess regularly implementation and whether it is sufficient to improve transparency in the derivatives markets, mitigate systemic risk, and protect against market abuse.8
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According to this summit, the OTC derivatives, for being some bilateral agreements taking place between two parties and not being disclosed to anyone else, were some shady transactions and this obscurity in the financial markets precluded measuring the real risk in the market. As a way to counter this, they came up with the idea that the OTC derivatives had to be standardized and brought to an exchange, whereby, the complexity of derivatives is minimised and all the transactions that take place between counterparties are known to everyone. This would render possible alleviating the opacity in the market and thus increasing market transparency. Furthermore, these transactions have to be cleared through a certain third counterparty known as a clearing house (CCP) that would lessen the counterparty credit risk and mitigate the systemic risk. Alongside CCPs, trade repositories would be adopted for reporting purposes in order to increase market information. The elimination of opacity and the increase in market information will be two very important factors that will prevent the investors from losing confidence and shy away from the market and serve as insurance against liquidity dryup. These measures would not be binding for only the US and the EU but for all great financial markets, considering that financial markets long have gone global rather than becoming fragmented and that there has to be a correspondence and compatibility in international markets so as to remove any possibility of a regulatory arbitrage. Overall, thanks to all these measures, the G20 people believed that the counterparty credit risk would be diminished, opacity-ridden market would be rendered more transparent, there would be more faith in markets and regulators would have more authority over markets. Standardization is the core measure that the G20 summit came up with. The role of standardization is clarified especially when it is taken into account that it is a measure which is extremely intertwined with the other measures that they suggested. Whats more, standardization is the key for the realization of them. As having a share in the benefits gained through all the other measures, standardization will be very helpful in order to eliminate the valuation problems that becomes extremely worrisome when a credit event occurs as well. Whats more, by standardizing derivatives, the market information will be more reliable. Here one thing is of great importance and it is that, while the OTC derivatives are standardised, all the incentives that will drive the market participants to use the non-standardised derivatives in order to avoid the central clearing and trading requirements have to be driven out.

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Effectively there are not many market makers that are providing liquidity to the markets. As their numbers being scarce and there are plenty of counterparties, this situation itself poses some giant risk for the system. Firstly, since there are not many market makers, a problem with one of them may become the problem of the whole system, since all the system is interconnected. A failure with the trade transactions of this dealer may easily pass to its counterparties, so making the whole system being in the middle of a contagion risk. This situation bears another story, too. Since in the OTC derivatives market, it is most often not known who is on the other side of the deal, this makes the market open to be exited by many investors since it is not known the counterpartys risk possibility. Collateralization is not of help here. Why? Its because although these deals carry a collateral, when investors leave the market and market becomes illiquid where practically no transaction takes place, the value of these collaterals will go extremely down to render the collaterals almost worthless. This means that all the system is at the curse of the counterparty risk that makes the market rather obscure and can be quite contagious. For these two risks that were aforementioned, namely counterparty credit risk and systemic (contagion) risk, it is the central clearing that is thought as being the recipe. First of all, central counterparties mutualize all the risks and thus drive off counterparty credit risk. In case that one party goes down, the chain-reaction events that took place after Lehman Brothers downfall will not be repeated. This means that, as these derivatives are cleared in the clearing houses, one party will not have to bear the burden of the default of its counterparty. As for the systemic risk, since the counterparty credit risk is zeroed out, the risk exposure of the counterparties is not an impossible riddle. Besides, the risk of one party is not the risk of all the market and thanks to centrally clearing, transparency reigns in the market which will cause the systemic risk to go down. However, the issue which of these derivatives will be cleared is still unclear. Yet, it is known that those derivatives that are not cleared centrally will be subject to higher collateral requirements in order to demonstrate the risk in them. It goes to show that any trade that takes place between only two parties will be more costly to either sides and it is a hint at how the G20 proposal relies on an extensive risk management program. Another point here to be made is that, those derivatives that will be cleared centrally, will be traded electronically, too. This is a good news for that the pricing of them will be known to public in a very short time, before it is too late unlike as it was before the financial crisis. Therefore, mispricing of derivatives will be improved for these electronically traded derivatives.
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Trading on exchanges alongside CCPs will make it possible to know the amount of transactions in the market, hence, the market information will be clear, both for the participants and for the regulators. However, there are some downsides to bringing these derivatives to exchanges. The first of them is that it can be harmful for the amount of trade that takes place in the market since some market participants will start to know their rivals positions in the market. The second one, as The Economist9 claims, is that, as posting a collateral will become an obligation, banks will take action in order to transform risky assets of their customers into safe ones, thereby demonstrating these customers portfolios more diversified and safer than they actually are, in return for a fee. This action itself is enough to take away all that is gained through bringing OTC derivatives to an exchange and take the newly regulated system all the way back. As a note to be made, there is an important distinction to be made between centrally clearing and trading on an exchange since oftentimes they are confused with each other and even sometimes mistakenly used interchangably. It is the clearing requirement that is stipulating the transactions be cleared by a third party, netting trades every day and obligating parties to post collateral, thereby, mitigating the risk of the counterparty and bringing transparency to markets. On the other hand, an exchange trade requirement is that the transactions will take place on an exchange rather than taking place as a bilateral agreement between two parties which is not disclosed to anyone else. Although the CCPs are deemed as a panacea for the OTC derivatives, it has to be known that it is not all rosy with them. With the implementation of CCPs, all the transactions are carried to clearinghouses which makes the risk to be concentrated only in those clearinghouses. It is good news that the counterparty risk is mitigated through these clearinghouses, but what if the clearinghouse itself goes down as it happened in 1987 in Hong-Kong when it ran out of resources and had to be bailed out? Ben Bernanke10 put it well:
If you put all your eggs in one basket, you better watch that basket. So the more

concentrated the clearinghouses become, the more strict regulation and supervision will be needed. Moreover, as there will be only a handful of CCPs and these parties will be clearing international deals too, to which country or jurisdiction they will be responsible to and in a credit event who will bail them out have to be explicitly determined beforehand. The aforementioned strict regulations and supervisions are also needed in order to not let these CCPs go astray while chasing profitable deals (such as accepting worthless collaterals just to win the deals) seeing that they are also profit-seeking institutions. Therefore, not to let history repeat itself and the Hong-Kong event recur, government have to obligate the clearinghouses
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to hold more equity unlike when LCH. Clearnet had only $463 million in capital against the $73 billion transactions that it conducted.11 However, it has to be stated that most of the arguments against the clearinghouses come from big players of the market (banks and other financial institutions) that try to avoid collaterals for which obscurity in the market comes in handy. Whats more, in that way they escape margining, too. As the picture looms bleak for big players, central clearing will be of a great help to small investors through minimizing the need of the due diligence to be done before any trade. Since this is a major hindrance in front of small investors that prevents them from entering the market, it is likely that there will be an increase the number of participants in the market. As one of the main problems with the derivatives was that they diminished the market information and caused the systemic risk be unknown in the market, reporting to trade repositories was imposed. Thanks to this, regulators will have more information about the market and they will be able to manage the systemic risk easier. Another advantage of trade repositories according to The Economist12 is that, in the absence of them market participants make too high an estimate of risk. The paper states that if the payments that Lehman had to make for settling its swaps tradings were not thought to be hundreds of billion dollars but just $6 billion as they were, the debt market would not be living such a chaotic situation.

The Dodd-Frank Wall Street Reform and Consumer Protection Act In line with the G20 proposals in the US, the government, as a response to the G20 summit took matchless steps oriented toward derivatives which resulted in a massive change in the financial markets unseen since the great depression. This expansive regulation scheme, which was named after Barney Frank and Chris Dodd, was designed due to the fact that 2008 global crisis made it necessary to have a better financial regulation. The main drive behind the act is shunning another Lehman-like crisis and the too big to fail concept that enabled some major institutions to lean on the taxpayer money. Yet, not only financial regulation but consumer protection, like keeping borrowers safe from abusive banking practices, also is the aim of the act. The major actor of the financial crisis, namely OTC derivatives are dealt with in the seventh title of the Dodd-Frank Act and the section is quite in line with the G20 proposals although its majority is related to swaps. 13 According to the Dodd-Frank Act, U.S. Commodity Futures Trading Commision (CFTC) and Securities and Exchange Commision (SEC) will determine what derivatives will
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be centrally cleared, taking into account notional amounts, liquidity, resources, market depth and the overall systemic risk. CFTC states that it is going to be non-financial hedgers that will be exempt from clearing, provided that they notify the CFTC about how they will handle the obligations they undertake13. This goes to show that the CFTC will keep a close watch on them to determine if they needed to be centrally cleared rather than go uncleared. Besides, clearinghouses will impose significant margin requirements on those non-centrally cleared swaps which may decrease their liquidity significantly. All the swap trades, either they are cleared or not, will have to be reported to swap data repositories, which will enable the public to have access to the data and prices soon and this will improve price transparency. However, in this case the names of the parties conducting those trades will be kept confidential, demonstrating that the aim here is only bringing transparency to the markets. This will eliminate the problem referred above that competing parties will be able to know their rivals hands which could diminish the amount of the trades. Furthermore, all parties to the transactions will have to register in order to make sure that they comply with the standards. As for the too big to fail danger, the act provides the orderly liquidation authority which is that a company on the verge of bankruptcy being dismantled in a careful way that no bailout will be needed. However, it is not known whether it will work for eliminating the too big to fail problem. Another step in the same direction will be the incorporation of The Volcker Rule. If incorporated, The Volcker Rule will prohibit proprietary trading, which is that a bank uses its own funds for profit purposes, and also will not let these banks or financial institutions invest in risky operations that can cause huge losses like hedge funds. Considering Morgan Stanleys $9 billion loss in 2007 on complex derivatives bet and JP Morgans $2 billion loss on 2012 which were two of the worst trades ever according to Business Insider14, it is possible that Volcker rule be quite effective in preventing huge losses by financial players in the industry. The regulations are so vast, complex and far-reaching that many inconsistencies inevitably emerge. This renders the act too difficult to grasp and too costly once it is in effect. Another side of the act is that it grants the government and its agencies an immense power in the control of the financial industry which can be considered even a little bit too much. This JP Morgan chart exposes well in what ways the regulatory authorities will be able to exert their power upon the financial players.

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The chart shows that the financial industry may be asphyxiated by the red tape created by the governmental institutions. Whats more, it is possible the agencies smother the financial industry with excessive regulations that there remains no financial innovation. As a result of that, it is possible that a big chunk of financial transactions be carried to elsewhere that will take the economy backwards. It also has to be envisaged that so much complexity will bring out so many loopholes to exploit that the act might become ineffective in some ways. Over and above, it may turn out that the costs as a consequence of the act actually surpassing the good that will come from it. The European Markets Infrastructure Regulation (EMIR) In the Europe in the third quarter of 2010, necessary actions started to be taken with the EMIR (European Markets Infrastructure Regulation). EMIR is consistent with the G20 rules, as well principally being in favor of risk mitigating and CCPs and financial stability. However, due to the late start of the negotiations about the EMIR and its proposals, it is estimated that, it will not be enacted till the end of 2012, which is the deadline put by G20, but extend well beyond 2012. The EMIR regime carries the same objectives with the DoddFrank and thats why they have many similarities although some differences and deviations could be pointed out, too. To begin with, the central clearing that comes out with the EMIR is not as strict as it is with the Dodd-Frank Act. In the EMIR, only those trades between financial counterparties, non-EU entities and the trades that exceed a certain brink between
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non-financial counterparties will be centrally cleared. Whats more, the central clearing of non-EU CCPs will also be accepted as it will be in the US, too. There will be a margin requirement on those transactions that are not cleared. For the reporting to repositories, the EU will behave in the same manner as the US. All these aside, there will be no counterpart for the Volcker Rule in Europe. According to Skadden15, some countries alongside the US and the EU countries have started to revise their regulatory systems. These countries are Japan, Hong Kong, Singapore, India, South Korea, Taiwan and China yet their reforms at the moment are at the assessment stage. CONCLUSION Although the pontifications of Warren Buffett when calling derivatives financial weapons of mass destruction have been verified by the occurrence of the recent global financial crisis, it should not be perceived that derivatives themselves are all corrupt and evil tools that bring nothing but calamities. It is true that credit derivatives can be considered as gambling in some ways and even the sole existence of OTC derivatives, mainly due to being off-balance sheet items, makes the financial world a more obscure place which has made them be outlawed by many countries. Yet, it has to be understood that they are very good tools that can serve as lubricant between the cogwheels of the financial system and provide liquidity to markets and help people manage their business risks. In the financial crisis too, it was not only the contracts themselves that flopped, rather it was the unhonorable behaviour of the people that ruined markets. Temptation made the crisis worse. As the financial regulation gets better, derivatives role in the future financial crises will diminish. The said reforms Dodd-Frank Act and the EMIR contemplate making effective changes in the use of derivatives to square the circle. This is a major step on the way to clarify market information and leave behind market distortions caused by it. However, the complexity coming together with the acts and the unintended consequences and loopholes must be addressed quickly. Potential inconsistencies between the Dodd-Frank Act and EMIR have to be negotiated bilaterally and addressed properly in order to ensure that there will not be potential problems arising from the jurisdiction differences since there are many global financial institutions in the OTC derivatives market. Otherwise as mentioned above, , it may turn out that the costs as a consequence of these reforms actually surpassing the good that will come from them.
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00144feabdc0.html#axzz2BR8O5peF 8- Retrieved from http://www.financialstabilityboard.org/publications/r_101025.pdf 9- Retrieved from http://www.economist.com/blogs/freeexchange/2012/09/derivativesmarkets-regulation 10- Retrieved http://www.federalreserve.gov/newsevents/speech/bernanke20110404a.htm 11- Retrieved from http://www.economist.com/node/21552209 12- Retrieved from http://www.economist.com/node/12552204 13- Retrieved from http://www.sec.gov/about/laws/wallstreetreform-cpa.pdf 14- Retrieved from http://www.businessinsider.com/the-worst-trading-losses-of-all-time2012-6?op=1 15- Retrieved from http://www.skadden.com/newsletters/FSR_A_Regulation_of_Over-theCounter_Derivatives.pdf
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