During the last years, there has been an increase in the use of derivative instruments, in addition to significant losses reported by companies and financial institutions, putting the appropriate use of this type of product in the spotlight. These instruments supposedly reduce financial risks, but, paradoxically, they are accused of producing new risks. However, are the derivatives themselves or their misuse to blame for these losses?
During the 2007-2009 global financial crisis, the misuse and abuse of financial derivatives was evident, especially in credit derivatives. In fact, to date, some institutional and retail investors have restricted their use, through either internal policies or local regulations. Consequently, numerous portfolio managers are reluctant to use these securities for investment and hedging purposes. Some financial directors are unaware of the ways in which derivative products can be used to streamline and restructure their organizations’ balance sheets, while the risk-return profiles of these products are also misunderstood.
As a result of the 2007-2009 global financial crisis, companies such as Lehman Brothers, Bears Stearns, and AIG became insolvent, practically bankrupt, or requiring government intervention. These events, together with the challenges of the Covid-19 crisis, have shown that a greater understanding of derivative products and their implicit risks is urgently required.
Uncertainty in handling derivative products can be reduced by means of a series of institutional modifications. A gradual integration of financial markets, better management, and closer supervision of derivative positions will provide better protection against their risks. This must also be accompanied by an appropriate regulatory environment, organizational risk management processes, and accounting standards to govern their use and limitations.
In the chapter “Governance Practices and Regulations for Derivative Products in Emerging Markets in the Wake of the Covid-19 Pandemic and the Subprime Global Financial Meltdown” (forthcoming), I have analyzed some of the key obstacles to launching successful derivative products in emerging economies and proposed policy actions.
Derivative instruments affected by Covid-19
In addition, in the chapter “Transformation of Derivatives Securities in Emerging Markets: Policy Implications in Light of the 2007-2009 Global Financial Crisis and Covid-19 Pandemic” (also forthcoming), I have examined some of the main barriers to launching derivative products in emerging economies and proposed practical solutions.
While the Covid-19 pandemic is not a subprime credit event, compared to everything that happened during the 2007-2009 global financial crisis, the current health crisis has implied new challenges and disrupted global financial markets as well as derivatives markets.
Even though the financial and social impact of the Covid-19 health crisis is yet to be fully felt, participants in the derivatives market could evaluate its effects on their trade agreements and counterparties.
The Covid-19 outbreak has already affected many aspects of the derivatives market and will continue to cause disruptions in the near future. With this in mind, OTC derivatives market participants need to carry out exhaustive reviews of the terms of their framework agreement negotiations with key counterparties, emphasizing, in particular, operational and force majeure provisions under the International Swaps and Derivatives Association (ISDA).
Some emerging markets have accelerated the process of opening their derivatives exchanges in order to compete with neighboring markets, even though their market microstructures and bases are incomplete. This occurs owing to the lack of knowledge and responsibility of public policy makers. Nevertheless, after operating for almost two decades, some of these operators are still too small for the size of their economies and the volume of negotiated contracts is not particularly significant.
I have observed that emerging countries have fallen into the trap of launching inefficient and illiquid derivatives markets and products, with many loopholes that could foment fraudulent acts, manipulations, abusive practices, and other types of misconduct.
During the past decade, numerous regulations have been introduced to address the operational deficiencies that were brought to light by the 2007-2009 financial crisis. In the Covid-19 crisis, the extent of derivatives market disruptions is yet to be seen.
References:
- Al Janabi, M.A.M. (2021), “Governance Practices and Regulations for Derivative Products in Emerging Markets in the Wake of the Covid-19 Pandemic and the Subprime Global Financial Meltdown” Çalıyurt, Kıymet Tunca (Ed.), Ethics and Sustainability in Accounting and Finance, Volume III. (In Press) [Publisher: Springer Publishing Co., Inc]
- Al Janabi, M.A.M. (2021), “Transformation of Derivatives Securities in Emerging Markets: Policy Implications in Light of the 2007-2009 Global Financial Crisis and Covid-19 Pandemic”, in Nugyyen, Duc Khuong, and Boubaker, Sabri (Eds.), Financial Transformations beyond the Covid-19 Health Crisis. (In Press) [Publisher: World Scientific Publishing Co., Inc.]
Further Reading:
1. Al Janabi, M.A.M. (2018), “Derivatives Products in Emerging Markets and Prudential Regulations”, in Claire Payne and Sidney Garcia (Eds.), Emerging Markets: Recent Developments, Challenges and Future Prospects, Nova Science Publishers, New York, USA. ISBN: 978-1-53613-039-3|.
2. Al Janabi, M.A.M. (2012), “Derivatives Securities in Emerging MENA Markets: Structuring Lessons from other Financial Markets”, Journal of Banking Regulation, Vol. 13, No. 1, pp. 73-85.
3. Al Janabi, M.A.M. (2008), “On the Appropriate Function of Trading Risk Management Units: Principal Objectives and Adequate Use of Internal Models”, Journal of Banking Regulation, Vol. 10, No. 1, pp. 68-87.
4. Al Janabi, M.A.M. (2008), “Internal Regulations and Procedures for Financial Trading Units”, Journal of Banking Regulation, Vol. 9, No.2, pp. 116-130.
5. Al Janabi, M.A.M. (2006), “Internal Risk Control Benchmark Setting for Foreign Exchange Exposure: The Case of the Moroccan Dirham”, Journal of Financial Regulation and Compliance, Vol. 14, No. 1, pp. 84-111.
6. Al Janabi, M.A.M. (2006), “On the Inception of Sound Derivative Products in Emerging Markets: Real-World Observations and Viable Solutions”, Journal of Financial Regulation and Compliance, Vol. 14, No. 2, pp. 151-164.
