The personification of capitalism in the world is mainly reflected in the global banking industry. Indeed, even among the most socialist jurisdictions, the banking industry has always managed to find a legal foundation to operate from a capitalist perspective (O’Brien, 2014b). It is, therefore, evident that in the extremely capitalist US economy, the banking industry has taken capitalism to the greatest extent and including a circumspect balancing act between legality and active fraud (O’Brien, 2014). Among the greatest capitalism instruments for world banking is the extremely ambiguous concept of derivatives. This concept has however, been indirectly blamed for the 2008 global financial crisis (GFC), which was the greatest of our times (O’Brien, 2014b). It is after the GFC, that the US government whose policy has always been non-interference with private commerce made such sweeping regulatory reforms in the banking industry that arguably made American banks handicapped in the international finance markets.
In law, every contract has an offer, acceptance and a mutual legal consideration. In similar manner, a derivative is a contract between two parties, mainly financial institutions such as banks and insurance players (O’Brien, 2014b). The ambiguity however, emanates from the lawful consideration. In a derivative, the product traded may either be an asset, and index or even an interest rate that one of the parties has some aspect of ownership over that is reducible into a deed. With time and deregulation, the products continued to be more amorphous until they were reduced to such amorphous assets as collateralized obligation and credit swaps (O’Brien, 2014).
Delegate your assignment to our experts and they will do the rest.
Therefore, derivative contracts are amorphous and high profit contracts due to the great risks involved. Indeed, conservative entrepreneurs like Warren Buffet’s Chief Executive of Berkshire Hathaway, considers them to be speculation akin to gambling. Unfortunately, GFC proved Buffet right and the government moved in to regulate this industry through the Dodd–Frank Wall Street Reform and Consumer Protection Act of 2010 commonly referred to as the Dodd-Frank (O’Brien, 2014).
With regard to the derivatives, the Dodd-Frank indirectly declared them as speculative investments that should not be carried out with depositor’s money. Further, the law also regulated how much of its own capital the banks can use to invest in derivatives. Any investment over 10% of the capitalization must undergo the often rigorous and time consuming process of board approval. Further, the Dodd-Frank Act made sweeping changes on the most common and most profitable forms of derivatives known as ‘swaps’ (Kaufman & Nelson, 2015). These are ambiguous over the counter agreements made between banking institutions and premised on mutual trusts.
The main premises for swaps was that the parties were safe as they were simply too large to founder (O’Brien, 2014). Under new regulations, there would be no swaps as all derivative transactions would be undertaken through clearing houses. The final critical form of regulation is transparency. Under Title VII of the Dodd-Frank law, there was going to be an advanced level of transparency on all derivative based transactions, which was another blow to the common form of derivative transactions especially in regard to swaps (Kaufman & Nelson, 2015).
The most significant implication of these regulations was the unavailability of funds for use in the often urgent derivative transactions. Derivatives are often floated on a ‘first come first served terms’ with the greatest advantage going to the party with ready funds (O’Brien, 2014). The extreme regulation creates a disadvantage for US players in the industry against the less regulated international players.
The second major implication is the reduction of risk. On the surface, this may look like a positive thing. However, in investment, higher risks will almost always come with higher profits. A speculator who can accurately foretell risks with a good level of accuracy makes for a perfect investor. Without the ability to make major risks, the derivatives market loses its appeal as a profit making venture. The upshot of the foregoing is that the post GFC regulations aforesaid albeit premised in consumer protection, crippled one of the fundamental ways that banks make profits.
References
Kaufman, G. G., & Nelson, R. W. (2015). The Dodd-Frank Act: Systemic risk, enhanced prudential regulation, and orderly liquidation. The First Great Financial Crisis of the 21st Century: A Retrospective , 9 , 249.
O’Brien, J. (2014). Too big to fail or too hard to remember? Lessons from the new deal on dealing with systemically important institutions. Law and Financial Markets Review , 8 (3), 249–259. doi:10.5235/17521440.8.3.249.
O’Brien, J. (2014b). Fixing the fix: Governance, culture, ethics, and the extending perimeter of financial regulation. Law and Financial Markets Review, 8(4), 373-388. doi:10.2139/ssrn.2529073
