Financial Crises and the Derivatives Markets

Derivative markets are believed to have been the cause of the last world financial crises. This is so because derivative markets come up with an inflated value of market capitalization which is very high compared to the same value when calculated by other means. Derivatives have also been criticized for not being real assets; they are just virtual securities with no tangible value attached to them. This has made the market capitalization to be misstated, which has caused adverse effects on the world economy when macroeconomic decisions are made based on these misstated figures. There were also no regulations on the trading of derivative markets up until the last financial crisis when these markets were reformed.

It was legislated that derivative markets and in general financial markets should have dynamic capital rules and high capital standards were put in place for these markets. The capital rules were to be dynamic so as to accommodate any other new rules that could lead to the improvement of financial markets. The capital standards were to ensure that the financial markets are stable. Financial firms were also required to engage in better risk mitigation strategies as derivative transactions had proved less effective than was considered before the financial crises. Financial institutions were to be audited by an independent body so as to make sure they conform to the new regulations.

For the well-functioning, efficiency, and sustainability of derivative markets, I would suggest there be put a maximum limit on the value of derivatives a firm can hold in proportion to its capital base. This will cub firms from entering into too many derivative transactions as this affects the risk levels of the business. For example, a regulation may be put in place that disallows a business from holding derivatives with a nominal value that is more than 10 % of the total market capitalization of the company.