Discussion from Investment Analysis and Portfolio Management at Boston University:
Quick breakdown of derivatives: Unlike stocks, derivatives are not traded on exchanges. They are bilateral contracts between a bank and another financial firm or a company. As a result, figuring out who is on the other side of a deal during a period of financial stress can become quite challenging. I highly recommend – especially for those pursing the MSBFSM degree – to watch the documentary “Inside Job.” It is an Oscar winning documentary that provides a comprehensive analysis of the global financial crisis and how derivatives played a role. Forewarning: it takes a stab at capitalism, which I’m sure is a touchy subject for anyone making or pursuing a career in the financial sector. Nonetheless, it’s informative. Watch it free here: http://www.filmsforaction.org/watch/inside_job_2010/
On to business: everything addressed about derivatives in this week’s discussion is true; they promote efficiency, however, many bankers do not understand the underlying risks. For instance, in a recent WSJ article, it was showcased that 13 of the 19 firms managed to report weekly data on derivatives contracts to a central database within three days—the standard set by regulators. Nevertheless, some other U.S. banks provided worse data in 2012 than in previous years, and eight European Union banks, one U.S. and, one Canadian firm couldn’t update critical metrics required by regulators (1).
In my opinion, I think there needs to be a well-defined transparent market for derivatives. If some firms don’t know what exactly is tied to what in some of their complicated products, I think that will prove to be a disastrous domino effect during a time of crisis. Finance is a powerful technology, and I think that finance professionals have a moral obligations to be responsible. After receiving the Deutsche Bank Price in Financial Economics, Robert Shiller said, “Finance is a powerful technology, but a technology that has been only imperfectly applied for the betterment of humankind”(3).
Europe is taking the charge on inputting regulation and transparency in the derivatives field; however, even the proposed regulations are choppy. Heck, in a recent press release, the European Securities Markets Authority said that it had asked the Commission "to clarify the definition of a derivative or derivative contracts” (2). If regulators and bankers don’t know what is considered a derivative, how can we even go about trying to regulate it?!
To clarify my thoughts: yes, I think derivatives can promote efficiency, especially in risk management. However, the instruments are currently so complex that it may produce entirely opposite results; since the products are intertwined they can increase riskiness in the entire financial market. Transparency regulations in the derivatives market need to clearly defined.
Josh
(1) http://blogs.wsj.com/moneybeat/2014/01/20/banks-remain-vulnerable-in-a-key-area-years-after-the-crisis/?KEYWORDS=Derivatives
(2) http://online.wsj.com/news/articles/SB10001424052702304703804579383054267338542?KEYWORDS=Derivatives&mg=reno64-wsj&url=http%3A%2F%2Fonline.wsj.com%2Farticle%2FSB10001424052702304703804579383054267338542.html%3FKEYWORDS%3DDerivatives
(3) https://www.db.com/presse/en/content/press_releases_2009_4619.htm
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