The Role of Derivatives in the Financial Crisis

Issue Briefs | Financial Crisis

No. 187
Tuesday, January 26, 2016
by Hector Colon

What role did derivatives play in triggering the 2008 financial crisis? Specifically, what part did credit default swaps (CDSs) play in spreading risk to the rest of the financial system and causing the failure of major institutions? And, what effect will the regulations implemented after the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act have on future derivatives markets?

What Are Derivatives? Derivatives are securities with a price tied to an underlying asset and can be classified into forwards, futures, options and swaps. These instruments are useful to businesses seeking to hedge their risks, whether they are a producer or consumer of agricultural products, metals or energy, or a pension fund needing to reduce its exposure to fluctuating interest rates.

Standardized derivatives have detailed terms and specifications for each class and series of contract and are usually traded on an exchange. Other types of derivatives are traded over-the-counter (OTC) and are unregulated. However, their implicit leverage and risk can be dangerous when used for investment or speculation without enough supporting capital.

Some financial institutions have experienced large losses from the use of derivatives and other forms of leverage. For example, Barings Bank lost $1.4 billion in 1994 and Société Générale lost $7 billion in 2008.
Nonetheless, losses would likely be greater if businesses did not use derivatives for hedging.

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