that same institution if that institution wants to either minimise risk or only retain only the risks that it has expertise in handling/
This is a good explanation.
http://www.financialpolicy.org/dscprimer.htmDerivatives contracts have been found written on clay tablets from Mesopotamia that date to 1750 B.C. Aristotle mentioned an option on the use of olive oil presses in his Politics some 2,500 years ago. The Japanese traded futures-like contracts on warehouse receipts or rice in the 1700s. In the U.S., forward and futures contracts have been formally traded on the Chicago Board of Trade since 1849. Today the size of derivatives markets is estimated by the Bank of International Settlements to exceed $109 trillion in outstanding contracts and over $400 trillion in trading volume on derivatives exchanges.
Derivatives are useful for hedging the risks normally associated with commerce and finance. Farmers can use derivatives the hedge the risk that the price of their crops fall before they are harvested and brought to market. Banks can use derivatives to reduce the risk that the short-term interest rates they pay to their depositors will rise against the fixed interest rate they earn on their loans and other assets. Pension funds and insurance companies can use derivatives to hedge against large drops in the value of their portfolios.
As an indication of the dangers they pose, it is worthwhile recalling a shortened list of recent disasters. Long-Term Capital Management collapsed with $1.4 trillion in derivatives on their books. Sumitomo Bank in Japan used derivatives their manipulation of the global copper market for years prior to 1996. Barings bank, one of the oldest in Europe, was quickly brought to bankruptcy by over a billion dollars in losses from derivatives trading. Both the Mexican financial crisis in 1994 and the East Asian financial crisis of 1997 were exacerbated by the use of derivatives to take large positions on the exchange rate. Most recently, the collapse of a major commodity derivatives dealer Enron Corporation has lead to the largest bankruptcy in U.S. history.
The first public interest concerns posed by derivatives comes from the leverage they provide to both hedgers and speculators. Derivatives transactions allow investors to take a large price position in the market while committing only a small amount of capital – thus the use of their capital is leveraged. Derivatives traded in over-the-counter markets have no margin or collateral requirements, and the industry standard has shown to be deeply flawed by recent failures.
Leverage makes it cheaper for hedgers to hedge, but it also makes it cheaper to speculate. Instead of buying $1 million of Treasury bonds or $1 million of stock, an investor can buy futures contracts on $1 million of the bonds or stocks with only a few thousand dollars of capital committed as margin (the capital commitment is even smaller in the over-the-counter derivatives markets). The returns from holding the stocks or bonds will be the same as holding the futures on the stocks or bonds. This allows an investor to earn a much higher rate of return on their capital by taking on a much larger amount of risk.
Taking on these greater risks raises the likelihood that an investor, even a major financial institution, suffers large losses. If they suffer large losses, then they are threatened with bankruptcy. If they go bankrupt, then the people, banks and other institutions that invested in them or lent money to them will face losses and in turn might face bankruptcy themselves. This spreading of the losses and failures gives rise to systemic risk, and it is an economy wide problem that is made worse by leverage and leveraging instruments such as derivatives. When people suffer damages, even though they were not counterparties or did any business with a failed investor or financial institution, then individual incentives and rules of caveat emptor are not sufficient to protect the public good. In this case, prudential regulation is needed – not to protect fools from themselves, but to protect others from the fools.
http://www.reason.com/news/show/29033.htmlThree of the six largest bankruptcies in American history -- WorldCom, Enron, and Global Crossing -- occurred between December 2001 and July 2002, shattering investor confidence and helping to knock 22 percent off the Dow Jones Industrial Average. The failures had more in common than just timing and size: All to varying extents involved the use of the controversial and poorly understood financial instruments known as derivatives.
In the season of finger pointing that followed, derivatives trading was singled out for abuse. "If you dig deep enough into any financial scandal," BBC business reporter Emma Clark claimed in February 2002, "you can usually find a derivative or two to take the blame." Howard Davies, chairman of the U.K. Financial Services Authority, told a conference the month before that an investment banker described to him one popular type of derivative (collateralized debt obligations) as "the most toxic element of the financial markets today." Even famed investor Warren Buffett warned that derivatives posed a grave threat to the global financial system. "We view them as time bombs, both for the parties that deal in them and the economic system," Buffett wrote in his 2002 annual report for Berkshire Hathaway. "Derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal."
The common denominator in all these products is that they allow companies and private investors to trade away risk with which they are ill equipped to deal and focus instead on taking risks in areas in which they specialize. Many international corporations, for example, use currency derivatives to swap out their exposure to exchange rate fluctuations. This allows them to focus on their core business while allowing professional currency traders to worry about international valuations.
<snip>In response to the various derivatives disasters (to individual institutions), many have suggested that the government should become more active in regulating these new markets. Sen. Dianne Feinstein (D-Calif.), following the Enron bankruptcy, proposed giving the Commodity Futures Trading Commission regulatory oversight over all derivative transactions. (Her proposal was defeated in roll-call votes in 2001 and 2002.) State agencies should certainly pay more attention to their own derivatives trading. But there are a number of pitfalls in increasing the regulation of private derivatives trading.
<snip>Government bailouts of failing investments create a similar moral hazard. The stronger the expectation of a government safety net, the less investors will concern themselves with the risks inherent in the investment. When the average private corporation makes a mistake with derivatives, it suffers a loss. After a few mistakes, it either goes out of business or learns its lesson and changes its practices. But large private hedge funds and money-center banks know that they are "too big to fail," at least in the government's eyes. In the event of a financial catastrophe, they expect to be bailed out by government deposit insurance and the Fed. Such bailouts came to be commonplace under Federal Reserve Chairman Alan Greenspan, especially when he was teamed with Treasury Secretary Robert Rubin.<snip>
...there are significant risks involved with the fantastic voyage finance has undertaken in the last 20 years. But increased government intervention is likely only to heighten that risk.
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