Caucus 3.6.12: The Derivative Market & Shadow Banking System

The Derivative Market & Shadow Banking System         

Advocate Perspective:

“Ultimately, derivatives offer organizations the opportunity to break financial risks into smaller components and then to buy and sell those components to best meet specific risk-management objectives. Moreover, under a market-oriented philosophy, derivatives allow for the free trading of individual risk components, thereby improving market efficiency. Using financial derivatives should be considered a part of any business's risk-management strategy to ensure that value-enhancing investment opportunities can be pursued.”

                – Tom Siems, Dallas Federal Reserve Economic & Policy Advisor

Source: http://www.cato.org/pubs/pas/pa-283.html

*Note this perspective is from 1997, before the two most significant financial system stresses that have occurred in the 1998 Failure of Long-Term Capital management and the financial crises of 2007-2011.

Critical Perspective:

·         Critic’s commentary on the possibility and implications of our next financial crisis that will likely be related to derivatives: http://www.zerohedge.com/contributed/coming-derivatives-crisis-could-destroy-entire-global-financial-system

·         NY Times article on Secretive Banking Elite who rule the trade in derivatives: http://www.cnbc.com/id/40628316/

·         In 1933 the Glass Steagall Act was passed in response to reform needed to avoid another Great Depression. The repeal of provisions of the Glass–Steagall Act by the Gramm–Leach–Bliley Act in 1999 effectively removed the separation that previously existed between investment banking which issued securities and commercial banks which made money through deposits. It was the repeal of these prohibitions that was later claimed by many to have contributed to the financial crisis of 2007-11 by allowing depositors' money to flow into risky investments. This has helped to create many large banking institutions that are “too big to fail” and justifications for government bail outs.  Source: http://en.wikipedia.org/wiki/Glass%E2%80%93Steagall_Act

·         Brooksley Born, the head of the Commodity Futures Trading Commission [CFTC], issued a warning in the late 1990s of the dangers of derivatives in our financial system. Her criticism was suppressed by the financial industry and some of Washington’s top regulators:  http://www.pbs.org/wgbh/pages/frontline/warning/view/

·         Federal Reserve Map of the Shadow Banking system: (Only referenced to note the complexity of the system map on page 3) http://www.ny.frb.org/research/staff_reports/sr458.pdf

Some Solutions:

·         Creating a Market Exchange for OTC derivatives. South Korea’s efforts: http://www.bloomberg.com/news/2012-01-12/south-korea-to-start-otc-derivatives-clearinghoue-to-reduce-global-risks.html

Complex systems are efficient but run with little margin of error. They breakdown less frequently but when they do the fail catastrophically. One framework to improve complex systems is through the application of the Principals of Resilience:  http://www.foreignpolicy.com/articles/2009/04/15/the_next_big_thing_resilience