Are Derivatives the Source of 2008 Global Crisis?
Derivative instruments, which originated for hedging purposes at the beginning, have gained further popularity with the usage of them as financial leverage. Rather than using them to hedge their portfolio risk, investors have begun to use these instruments for speculative purposes in huge amounts. In year 2007, derivatives despite their complexity and lack of transparency, have constituted the greatest portion of the bank assets especially the assets of investment banks. Moreover, since regulatory bodies are not authorized to regulate or to control usage of these instruments, the risk in banking sector has increased. This risk resulted in global financial crises with the inability of banks to deal with their liabilities.
The origins of derivative instruments basically go back centuries ago. However, these instruments especially gain importance after the collapse of Bretton Woods International Payment and Exchange Rate System. In 1973, when the exchange rates were left to fluctuate freely together with already fluctuating interest and inflation rates, the new risk perception required use of some instruments to hedge increased risk (Nurcan, B, 2005). These instruments are issued on many assets such as gold, securities, commodities, foreign exchange or interest rate. Derivatives which are broadly categorized as swaps, options, futures or forwards can be used for two main purposes: hedging or speculation. Hedging is the action in case of uncertainty in underlying market while speculation is the result of benefiting the volatility in the price of the assets. In time, with the investment behaviors of those who wants to benefit from price volatility, speculative purposes dominate the hedging one.
According to Aşıkoğlu (2008), when these instruments are used in line with their main functioning for which they were originated, hedging, they ease the process of economic system, transform it into more stable structure and provide efficient risk management. However, if they are used for the aim of speculation, they may result in big earnings or losses for investors. The change in investor behaviors, seeking for speculative profit, resulted in accumulation of further risk on banks’ balance sheets. This process brings global financial system to the crises in 2007, with insufficient control and regulation on banking sector.
THE MECHANISM BEHIND THE CRISIS
The volume of the transactions based on these derivative instruments rose gradually when year 2007 came. Mortgage backed securities and credits default swaps were the main types of assets which banks prefer to keep. However lack of transparency on this transactions and the inability of authorities to regulate these transactions made the situation very risky. Since these instruments can be traded over-the-counter, the risk of one party turns into the risk of others, the counter-party risk, and the risks they contain are not visible or reportable anyway. The tables below show how the volume of derivative transactions increases in recent years, especially in 2007.
The system is not able to observe and regulate the risks which over-counter-transactions include. For example, credit default swaps are the contracts which enable the creditor a kind of insurance in case of event of default of borrower. While traditional insurance products are already able to insure against such risk, the reason for using CDS rather than standard insurance is unfortunately to evade regulation governing traditional insurance products (Murphy, R, 2009).
Without any regulation or any limitation, in USA which is accepted as starting point of the crises, the largest portion of portfolio of investment banks was made up these contracts. In the world, in 2008, the volume of these transactions reached $526 trillion, which is 10 times larger than whole world production in that period (Kayahan, C, 2009). As a result, banks ended up storing an enormous quantity of debt which turned out to be highly toxic.
In USA, the crisis started in real estate market. The mortgage bubble could not be sustained when housing prices began to stagnate. Individuals started to sell off their real estate in such settings. With the increase in interest rate by FED, the periodic payment amount of the credits with variable rates increased. Repayments became problematic. The derivative instruments which derive their value from the underlying assets deepened severity of the situation. These derivative instruments, which had been issued in enormous amounts already, enforced the market to extend beyond its natural limits. The ones who participated in high risk portfolio investment could not manage to collect the payments and were brought into a desperate situation. This resulted in credit crunch and collapse of global investment institutions.
In contrast to the countries with highly institutionalized and developed financial markets, the countries recently using the derivative instruments experienced the global crises in a protected environment. Moreover, most of these countries were the ones who experienced real sector crisis in their recent history and therefore, they had regulated banking and financial sector. This is the reason why they were able to recover the effects of the crises especially in their financial markets. This further explains the point that the use of derivative contracts in a deregulated environment leads to crises with the risk they contain. Turkey is one of the countries which do not issue or trade such instruments heavily. These instruments are newly introduced in Turkey and following table shows how the volume of transactions based on these contracts is low.
The next table further helps to show the gap between Turkey and other regions in terms of derivative transactions.
It is not any derivative instrument itself the source of current financial crisis. These instruments were originated to provide a stable financial environment with controlled risk. Though, the use of these contracts in a speculative profit seeking manner as a financial leverage without any systematic control over the risk accumulated in the system is the main reason of the crisis. In this point, countries have begun to take actions to regulate those transactions, the banking sector and the investment institutions to limit and to control with the help of a supervisory body till new complex tools will be created.
Kifaye Didem Yeşiltan, Turkish Treasury
Please cite this publication as follows:
Yeşiltan, Kifaye D. (January, 2013), “Are Derivatives the Source Of 2008 Global Crisis?”, Vol. I, Issue 11, pp.9-14, Centre for Policy and Research on Turkey (ResearchTurkey), London, ResearchTurkey. (http://researchturkey.org/?p=2622)
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