Key Issues in Derivatives Reform (CRS Report for Congress)
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| Release Date |
Revised June 22, 2010 |
| Report Number |
R40965 |
| Report Type |
Report |
| Authors |
Rena S. Miller, Analyst in Financial Economics |
| Source Agency |
Congressional Research Service |
| Older Revisions |
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Summary:
Financial derivatives allow users to manage or hedge certain business risks that arise from volatile commodity prices, interest rates, foreign currencies, and a wide range of other variables. Derivatives also permit potentially risky speculation on future trends in those rates and prices. Derivatives markets are very large--measured in the hundreds of trillions of dollars--and they grew rapidly in the years before the recent financial crisis. The events of the crisis have sparked calls for fundamental reform. Derivatives are traded in two kinds of markets: on regulated exchanges and in an unregulated over-the-counter (OTC) market. During the crisis, the web of risk exposures arising from OTC derivatives contracts complicated the potential failures of major market participants like Bear Stearns, Lehman Brothers, and AIG. In deciding whether to provide federal support, regulators had to consider not only the direct impact of those firms failing, but also the effect of any failure on their derivatives counterparties. Because OTC derivatives are unregulated, little information was available about the extent and distribution of possible derivatives-related losses. The OTC market is dominated by a few dozen large financial institutions who act as dealers. Before the crisis, the OTC dealer system was viewed as robust, and as a means for dispersing risk throughout the financial system. The idea that OTC derivatives tend to promote financial stability has been challenged by the crisis, as many of the major dealers required infusions of capital from the government.
