The Wonderful World of Derivatives

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For my last post, I focused on the warning signs that some regulators saw years before the near collapse of our financial system. I also discussed in the post and in some comments, the role that deregulation played in the recession. For my paper, I am going to continue to explore these ideas, however, I am going to shift my focus towards the derivatives. I want to know everything about the regulatory environment that enabled the reckless and secretive trading of securities. I also want to explore where the underlying securities came from. In understanding the transformation process of mortgages, or other financial instruments, were turned into tradable securities, I will be able to place that within the regulatory framework and gain a full picture of the environment that led to the recession.

I will be looking at the differences in Over The Counter (OTC) derivative trading as compared to Exchange Traded Derivatives (ETDs). The latter are regulated like other securities and are traded on a transparent open market, whereas the OTC derivatives trading is private agreement between two parties. While it can be argued that derivatives allow investors to hedge their bets and limit potential losses, having an opaque market like the OTC trading, can lead to great systematic risk. I found an interesting study of derivatives trading in the Korean market and the role deregulation played in their financial melt down of 1997. This, I hope, will allow me to draw some parallels between what occurred in Korea in the late 1990s to what happened to our financial system last year. By understanding the process and understanding the effects of deregulation, I expect to be able to identify some of the warning signs that regulators at the CFTC saw.

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4 Responses

  1. I love that you included the share button!

  2. I think this is going to be an interesting way to approach the causes of the recession. However, I have the feeling it could get complex and confusing quickly. I agree that looking at what happened in Korea might be a good way to help shift through that confusion; but you should be sure to take the differences between the Korean and American markets into account before you draw any conclusions.

  3. I think it would be really helpful for you to look at the regulations that were in place prior to the financial crisis and see why they failed. Maybe that will help you draw more comparisons between the US and Korean melt downs. Also, you could look to see if anything has changed and whether or not there are new regulations in place for trading derivatives.

  4. The natural comparison of OTC vs ETDs makes for a straight forward research agenda. I look forward to learning about the two. I think the theoretical angle is possibly the idea of market transparency and who actually advocates for that versus arguments that center on the idea that these are “too complicated” or “too special” to be forced into ETD markets.

    There is an area of study called economic sociology which may provide some insights. Also, I am sure you will find think tanks that focus on economic or financial policy weighing in on these.

    It would be nice to have the citation for the Korea study. Financial research is a booming area, so I don’t think you’ll have trouble finding something. Understanding it may be another issue.

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