Financial instruments of destruction12/8/2022 ![]() ![]() As once pointed out by Warren Buffet, “Derivatives are financial weapons Even though, these instruments are used to deal with the inherent risk associated with finance, they can be the cause of destruction if not used cautiously. With the total notional amounts outstanding on over-the-counter derivative contracts amounting to around nine times global GDP by the end of June 2012, they represent by far the largest financial transaction in the world. (22) The FRB should revise Regulation W so.The growth of the amount of financial derivatives during the last fifteen years has been phenomenal. (21)ĭespite the negative effect of these standards, the Federal Reserve Board ("FRB") has not yet revised Regulation W to define "credit exposure" in light of the passage of Dodd-Frank and the amendments to Section 23 A. (20) These standards, such as limiting transactions between member banks with any of their affiliates to those transactions of less than 10% of the bank's available capital, affect how some banks manage their risk and could increase the systemic risk of banking institutions. (19) If these transactions create credit exposure, the amendment requires that the transactions meet certain qualitative, quantitative, and collateral standards set forth in Section 23A. The amendment to Section 23A in the Dodd-Frank Act requires that all derivative transactions with bank affiliates, including those used for hedging purposes, are to be considered "covered transactions" to the extent that the transaction causes a member bank or a subsidiary to have credit exposure to the affiliate. (16) However, it does not differentiate between the two in its changes to Section 23A of the Federal Reserve Act ("Section 23 A") (17) and Regulation W, the statute and Federal Reserve regulation governing transactions between Federal Reserve member banks ("member banks") and their affiliates. (15) Dodd-Frank actively distinguishes transactions for speculative purposes from those used for hedging in a number of its sections. (14) Passed in 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act ("Dodd-Frank") addressed many of the speculative uses of derivatives that were seen as contributors to the financial crisis. (13)įollowing the financial bailout of AIG and others, Congress sought to institute new regulation to restrict speculative derivative transactions. (11) These hedging transactions are common practice for financial and nonfinancial institutions as a way to limit their losses, and are a major component of risk management for many companies, (12) including Warren Buffet's Berkshire Hathaway. ![]() (10) These hedging derivatives, as opposed to speculative derivatives, can reduce losses when goods, currency, securities, or resources a company relies on fall in value. (9) Common derivative products, such as futures, forwards, options, and swaps, are regularly used in risk-mitigating transactions to hedge against investments in all industries. However, not all derivative transactions are like the highly speculative trades that helped bring the financial markets to the brink of collapse. (7) The outcome of such a dramatic event during the financial crisis has caused derivatives to be generally seen as risky and dangerous financial products. (4) Warren Buffet famously called derivatives "financial weapons of mass destruction." (5) These financial products played a role in exacerbating the financial crisis, (6) in particular AIG's spectacular credit default swap losses and its resulting bailout. (1) Much has been made of speculative derivative products, as they are often cited as causes of the Financial Crisis of 2008 ("the financial crisis") (2) and have been made infamous by Hollywood movies (3) and congressional hearings. Derivatives are one of the most misunderstood products in our financial markets today. ![]()
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