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 Cömert

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 party’s 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

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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. What’s 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

party’s 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. That’s 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. What’s 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 today’s 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 side’s gain is equal to the other side’s 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.

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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 party’s, 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 B’s obligation and B taking up A’s. 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.

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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.

Let’s 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 investor’s

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 entity’s 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 borrower’s default would not trigger some other’s. 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

tricky gifts that CDSs granted to the market was that it was not obligatory to own anything

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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

are a different kind of gamble that people play, only with more far-reaching outcomes

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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 Moody’s 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-B’s,

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

lending was so much at ease at that time in the US that there were many people who in fact

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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 marked-

to-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

financial parties (as it was the case with the AIG) or threatening them to take their business

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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. What’s 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.

What’s 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.

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

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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 counterparty’s risk possibility. Collateralization is not of

help here. Why? It’s 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.

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

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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 Bernanke 10 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

to hold more equity unlike when LCH. Clearnet had only $463 million in capital against the

$73 billion transactions that it conducted.11

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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. What’s 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

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

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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 rival’s

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 Stanley’s $9 billion loss in 2007 on complex derivatives bet and JP Morgan’s $2

billion loss on 2012 which were two of the worst trades ever according to Business Insider 14,

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. What’s 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 Dodd-

Frank and that’s 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. What’s 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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REFERENCES

Durbin, M. (2011). All about derivatives. (2nd ed., p. 11). NY: McGraw-Hill.

Retrieved from http://www.bis.org/statistics/otcder/dt1920a.pdf

Gibson, M. (2007), “Credit Derivatives and Risk Management.” Board of Governors of

the Federal Reserve System Finance and Economics Discussion Series paper 2007-47

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00144feabdc0.html#axzz2BR8O5peF

8- Retrieved from http://www.financialstabilityboard.org/publications/r_101025.pdf

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10- Retrieved from

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-time-

2012-6?op=1

15- Retrieved from http://www.skadden.com/newsletters/FSR_A_Regulation_of_Over-the-

Counter_Derivatives.pdf

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