The financial sector in the USA has seen a rapid and innovative growth for the last 50 years. In the 1970s, this sector had experienced the hardest turbulence as the country faced an economic decline in its most critical areas. Back then, oil shocks affected the country, the country stock market was in decline, and inflation was very high. Due to these effects, financial derivatives were formed to make sure that future downward movements in the financial sector were avoided. The financial derivatives enabled the investors and financial institutions to hedge in the future position to prevent unforeseeable risks. Thus, they were able to eliminate the turbulence in the economy (Colander et al., 2009). Since then, the derivatives markets have formed a critical part of the US financial sector. They were also extensively used right before the 2008 financial crisis. Furthermore, they have been in use even after the crisis. The paper will perform a critical analysis of the development and use of financial derivatives in the US market after and before the 2008 financial crisis.
The US Derivative Market before the 2008 Financial Crisis
The US 2008 financial crisis remains a dilemma to the majority of financial analysts and economists because the primary cause of the crisis has never been identified so far. The lack of historical information on why the crisis has occurred is quite a risky issue, as it prevents the policy makers in the sector from formulating policies that prevent such occurrences in the future (Helleiner & Thistlethwaite, 2013). One thing that remains known to all scholars in the US financial sector is that derivatives formed an important part of financial transactions right before the crisis. Therefore, they might have also played a role in the occurrence of the crisis.
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By the year 2008, all banks and other financial institution in the US market had accepted derivatives to be active securities, and thus, they traded with them comfortably without any fears. On the other hand, the investors had little idea about the derivatives market, but they were confident trading with them because unlike the loans, derivatives attracted more investors (New York Times, 2012). The investors also believed their investments were safe by the use of derivatives because the rating agency, which had been created to supervise derivatives market, also accepted that they were safe.
However, it occurred that in between 2007 and 2008, the number of credit-worthy customer in the banks had reduced remarkably. These clients had already invested in other banks; thus, banks were in a serious urge to attract more customers so that they could retain their income. With the use of derivatives, the banks turned to the subprime borrower to fill the vacuum left by the credit-worthy customers (Schwarcz & Sharon, 2014). The banks provided loans, which were poorly secured using derivatives, to this newly created customer base. The investors into the pension schemes and mortgage companies did not hesitate to continue investing in the industry.
At that point, the trend of derivatives revealed few things that were critical for the future of the US financial system. First, the banks did not have proper regulation on how to use derivatives in the market. If they had any regulations, they would have avoided the poor securing of the investment by the bank using weak underlying security. However, this did not happen; thus, the banks went on to determine what derivatives could do, yet in reality, they could not do anything. The banks also had started misusing the real meaning of derivatives in the market as per the occurrence in this period (Colander et al., 2009). When they were introduced, derivatives were a financial innovation dedicated to the avoidance of future risks through hedging in a future position. However, the financial institutions in the USA had taken advantages of the derivatives market, and they made profit from such a market. Loans were no longer profitable enough; hence, the financial institutions saw a chance of maintaining a steady income by using derivatives, which was wrong.
Another development in the derivative market during this period was that the body, constituted to regulate the field, did not have the clarity on what its duty was exactly. The rating agency, which approved the use of derivatives by banks by allowing the subprime borrowers to enter into the market, saw no problem in the new strategy. Hence, they accepted it as secure and safe for the investors. However, they failed to understand the underlying role of the derivative market; they had no clear regulations that could guide them in identifying inconsistency and criminal involvements of the banks in the market (New York Times, 2012). If there were well-stated rules and regulation regarding the use of derivatives, this agency would have realized that for the banks to make the profit from them would not turn out well for the industry.
Lastly, the investors were also in the dark concerning the operations of the derivative market in the US financial sector. Unlike the loans, of which security they were sure, they did not have any idea on how secure derivatives were concerning their investment. Therefore, these investors looked up to the rating agency to help them determine the safety of the investment. As stated above, the rating agency had full approval of derivatives, and thus, the investors had no other option but to continue investing in derivatives (Colander et al., 2009). The financials situation on the onset of the crisis was such that investors continued to have a large stock of derivatives, which they were convinced of being secure, and the banks had a significant amount of these securities, which they were reaped profit from. Furthermore, rating agency was fine with the situation. Many financial and economic analysts mutually agreed that such risky and an unregulated derivative market was a primary reason that the crisis had occurred.
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The Derivative Market in the USA after the 2008 Financial Crisis
As analyzed in the trend of the US derivative market above, the financial crisis could have happened due to lack of regulation in the industry. Just after the crisis had ended in 2009- 2010, the policy makers already pushed for reforms in the industry. When the new government assumed office in 2009, it promised that it would come up with the improvements in the US financial market (McCoy, 2013). President Obama gave his suggestions on the possible changes that he believed were necessary for the United States financial sector. His proposal was forwarded to the Senate and the House of Representatives finance committees who were tasked with coming up with the necessary reforms.
The two chair of both houses finance committees worked hand in hand in creating significant changes in the financial sector, and by the year 2010, the Dodd-Frank law was passed. The law had 398 rules, which was meant to create an accountable, transparent, and reliable financial sector in the country (Helleiner & Thistlethwaite, 2013). It also empowered two central agencies with the role of implementing the rules of the Dodd-Frank law. The first agency was the Commodity Futures Trading Commission (CFTC); this agency was tasked with the role of supervising the derivative market linked to the oil sector, the crops sectors, and for other commodities in the US market. The second agency was Securities and Exchange Commission (SEC) that focused on the security-based derivatives (Protess, 2012). With these two bodies, the two Houses were fully satisfied that fair rules proposed in the bill would be implemented in the right manner.
The USA was the first country to have a law that regulated the dividends markets; thus, many things were needed from these agencies for them to succeed in their duties. They seemed comfortable with their new roles because a few months after their formation, they were quite successful in their activities. These agencies first focused on attaining a sound financial sector in the USA that saw substantial progress in the initial stage. They were able to implement sound rules that introduced some competition in the industry that was not seen before (Protess, 2012). They also enhanced safety within the market by formulating rules that increased transparency.
However, the implementation of the Dodd-Frank law was not as consistent as initially planned. It appears that there are inhibitors always in place to ensure that the government does not adequately regulate derivatives. The reason for these hindrances mainly comes from the financial institutions who reap hefty profits from derivatives. Banks receive multi-billion dollar profits on the annual basis, and any implementation of the proposed rules could mean that they must forgo these benefits. Therefore, the banks have always objected the implementation of the Dodd-Frank law by involving courts into the implementation process. For example, in 2011, the CFTC passed a rule, providing that all financial institutions were to be limited to the number of derivative contracts that they had at a given time (McCoy, 2013). However, after the big banks launched a case, a federal court in Washington DC blocked the rule, stating that the Dodd-Frank bill had significant ambiguity.
Congress has also played a significant part in ensuring that the reforms in the Dodd-Frank law were not entirely implemented. Several Republican member of Congress have always argued that regulating banking industry would hinder their activities. Together with some members of the Democratic Party, they have always objected any proposal to change the agencies role in regulating the derivatives market. For example, in March 2013, the House Agriculture Committee passed eights rules that would enable the regulations of derivatives and swaps in the market. However, these rules were rejected by the House, which was a major blow in the implementation process (McCoy, 2013). There was a speculation that those who dismissed the bill had received a considerable compensation from the financial institutions.
Apart from the above challenges faced in reforming the derivative market, the international industry has also brought problem in the implementation process. Most of the US financial traders, who often use derivatives, transact in the global market; thus, they need to have harmonized rules across these nations (Schwarcz & Sharon, 2014). The USA, being among the few countries with derivatives reforms, is forced to wait or delay its implementation until all its foreign traders implement the same rules.
The current development of the derivatives market in the USA after the crisis has revealed that more should be done in regulating the market. The market is the same as it was before the crisis because no significant changes have taken place. The banks still make the profit using the derivatives, which was the case before the crisis. The agencies created to oversee the trading of derivatives are also toothless because they are regulated by the financial institution, courts, and Congress (Schwarcz & Sharon, 2014). It clear that the US derivative market remains unsafe for trading as far as proper regulations have not bee implemented.
The paper has given an analysis of how the US financial derivative market has changed by comparing the situation of the market before and after the 2008 crisis. It has been revealed that before the crisis occurred, the derivatives had been unregulated, banks had used them to make profits, the investors did not know how they worked, and the rating agency was not clear on its role in regulating derivatives. After the crisis, the Dodd-Frank law was passed, aiming to bringing reforms in the sector. However, due to the influence of financial institutions, legal cases, and the lack of Congress wiliness to bring change, the status of the financial sector is still poor, as no detailed regulations have been adopted yet. The paper has concluded that the US still faces a problem of a financial crisis in its current situation.