The Role of Derivatives in the Economy
Each part of our nation’s economy relies on a well-functioning derivatives marketplace. It is essential so that producers, merchants and other end-users can manage their risks. It allows those companies to lock in prices for the future. These markets have been around since the time of the Civil War.
Initially, there were futures on agricultural commodities, such as wheat, corn and cotton. They allowed farmers to get price certainty on their crops before harvest time. They also allowed farmers and producers to get the benefit of prices on a central market rather than just relying on the local merchants.
The markets have grown to include contracts on energy and metals commodities, such as crude oil, heating oil, gasoline, gold and silver, and contracts on financial products, such as interest rates, stock indexes and foreign currency. Based on your earlier show of hands, it is likely that your portfolios of companies include at least some companies that use those derivatives markets to hedge their risk. The price certainty that these markets provide allows companies to better make essential business decisions and investments.
Changes in the Derivatives Markets
These early derivatives, called futures, are currently regulated by the CFTC, after first coming under regulation in the 1920s.
In 1981, a new derivatives product appeared, which was transacted off-exchange. These derivatives, called swaps, were unregulated and largely will remain so we complete implementation of the Dodd-Frank Act, which became law last summer.
Since the 1980s, the swaps marketplace has evolved significantly. It also played a significant role in the 2008 financial crisis. From total notional amounts of less than $1 trillion in the 1980s, the notional value of this market has ballooned to about $300 trillion in the United States – that’s approximately $20 of swaps for every dollar in the U.S. economy.
It has now been more than two years since the financial crisis, when both the financial system and the financial regulatory system failed. Still, the effects of that crisis remain. I suspect few of your portfolio companies made their budgets in 2009, and many may still be below the growth for which you had planned.
We still have high unemployment, homes that are worth less than their mortgages and pension funds that have not regained the value they had before the crisis.
Though there were many causes to the crisis, it is clear that swaps played a central role. They added leverage to the financial system with more risk being backed up by less capital. U.S. taxpayers bailed out AIG with $180 billion when that company’s ineffectively regulated $2 trillion swaps portfolio, which was cancerously interconnected to other financial institutions, nearly brought down the financial system.
These events demonstrate how swaps – initially developed to help manage and lower risk – can actually concentrate and heighten risk in the economy and to the public.