In Defense of Derivatives
October 7, 2015
Most large businesses use derivatives to hedge their business risks, from agricultural products, to metals, to energy. Derivatives also provide implicit leverage and risk and can be dangerous when mismanaged.
Derivatives have even been described as "financial weapons of mass destruction" and have erroneously been blamed for the 2008 financial crisis, but the truth is derivatives were not systemically important, it was nonderivative mortgage products that caused losses throughout the crisis.
The losses of this crisis, however, were predominantly the result of excessive nonderivative leverage and investments in nonderivative mortgage products that fell dramatically in value. The only exception was AIG whose failure was due to losses partly from credit default swaps.
- The importance of derivatives in the economy can be measured by the number of global firms using them.
- In 2001, 88% of almost 7,000 nonfinancial firms with listed stock across 47 countries used derivatives.
- Derivatives enable those companies to run large-scale operations without having to bear enormous risks that could threaten their survival.
At present there is momentum to regulate the derivatives markets, even though they did not cause the financial crisis. But derivatives should not be considered in isolation and a reduction of derivatives risk will result in increased business risks.
Mandatory clearing of "over-the-counter" derivatives traded between private counterparties, instead of traded over an exchange will probably not reduce systemic risk. Also, margin requirements on uncleared derivatives may reduce risk in derivatives markets, but at the cost of increasing other business risks.
Therefore, a policy pursuing holistic risk management, reporting, and supervision would be more successful in reducing systemic risk.
Source: Bruce Tuckman, "In Defense of Derivatives," Cato Institute, September 29, 2015.
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