A Primer on Derivatives

Their Mechanics, Uses, Risks and Regulation

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Although criticized often and considered unfathomably complex, "derivatives" are relatively straightforward financial contracts that are not inherently riskier than other, more traditional financial instruments.  Derivatives are simply contracts created by the negotiation of two parties that derive their value from some underlying asset price, reference rate, or index level.  This primer explores the mechanics, benefits, risks, and regulation of the two types of derivatives contracts:  those which are traded on organized financial exchanges, and those which are privately negotiated.

Aside from explaining this innovative and growing area of financial activity, this primer also provides support for the following main conclusions:

(1) Derivatives are not hopelessly complex.  The essential economics behind most common derivatives transactions can be explained with a minimum use of either terminology or mathematics.  Once the basic principles are grasped for the two "building blocks" of derivatives — forwards and options — all other derivatives can be viewed simply as various combinations of these two product types.  Understanding the two building blocks of derivatives also provides new insights into more traditional financial products.

(2) Derivatives can provide significant benefits to all sorts of institutions, including banks, thrifts, institutional investors, government-sponsored enterprises, and retail investors.  Using derivatives can enable institutions to lower their funding costs, diversity their funding risks, manage the risks of asset and liability portfolios, change their exposure to an existing product or asset market at low cost, manage business expansions, and exploit informational advantages.  Derivatives also benefit the economy and financial system by promoting sound risk management policies and procedures to derivatives participants that are applicable to their whole institutions.

(3) The risks of using derivatives are not inherently different from the risks of using more traditional financial products, such as mortgage loans.  With proper risk management procedures and internal controls, there is no reason a priori why corporations that use derivatives should be subject to any greater financial risk than those which do not.

(4) Exchange-traded and privately negotiated derivatives are fundamentally similar products, but they also exhibit important complementarities and differences.  These two types of derivatives have evolved side by side and coexist for a reason.  They are both fundamentally derivatives contracts, but the risks and uses of the two products can differ dramatically.  It is appropriate to differentiate between them accordingly.

(5) Contrary to claims that derivatives activity is largely unregulated, the regulation of derivatives users and derivatives contracts is, if anything, excessive.  Privately negotiated derivatives have witnessed dramatic growth over the last decade in large part because banking regulators have promoted market discipline and a "flexible supervision" rather than a "strict regulation" approach in handling derivatives activities at banks.  Competition among regulators, furthermore, has mitigated the costs of regulation without jeopardizing the taxpayer-funded Bank Insurance Fund or the stability of the financial system.

At the same time, participants in U.S. exchange-traded derivatives activity, including organized commodities exchanges, have been subject to unnecessarily strict and inflexible regulation by the Commodity Futures Trading Commission, an agency with a statutory monopoly over the regulation of these exchange-traded products.  Such regulation has impeded growth and inhibited organized exchanges in their quest to innovate and remain competitive.  Because of the complementarities between exchange-traded and privately negotiated derivatives, all derivatives participants would benefit from a roll-back in the current regulation of exchange-traded derivatives activity.

(6) There is no "market failure" in derivatives.  A market failure is thought to occur when market participants fail to take actions that ensure either an efficient allocation of resources or adequate self-policing against excessive risk-taking and abuses.  This paradigm has provided the justification for most economic regulation since World War II.  Some areas thought to be "market failures" in derivatives include inadequate voluntary risk disclosures, lack of management understanding of derivatives, inadequate capitalization of dealers, the absence of a clearinghouse for privately negotiated derivatives transactions, and the growth in the number of dealers that are largely unregulated.  Analysis of each of these concerns reveals that there is no market failure.  Calls for further regulation of derivatives thus are built on a house of cards and would do little more than needlessly promote the expansion of bureaucracy at the expense of the competitiveness of U.S. financial institutions.