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Did Derivatives Get a Bum Rap?

Bruce Tuckman_article

The losses and failures of the financial crisis were predominantly the result of nonderivative leverage and investments in nonderivative mortgage products that fell dramatically in value.

Derivatives caught a large share of the blame for causing the 2007-2009 financial crisis, and as a result, certain provisions of the Dodd-Frank Act aim squarely at regulating their use. Now Bruce Tuckman, clinical professor of finance at NYU Stern, has produced a strong case as to why the black mark on derivatives – and the regulation it triggered – may be misguided.
 
In "In Defense of Derivatives: From Beer to the Financial Crisis," published by the Cato Institute, Professor Tuckman, a former managing director at four large investment banks, describes the central role derivatives have played across industry sectors, noting that the vast majority of large businesses, whether they produce beer or deal in stock futures, depend on derivatives to hedge their risk.  It’s a system that has worked well, he writes. During the crisis, other than in the case of AIG, derivatives were largely irrelevant to the failure of big firms, most of which had toppled prior to AIG’s failure. “The losses and failures of the financial crisis were predominantly the result of nonderivative leverage and investments in nonderivative mortgage products that fell dramatically in value,” he argues.
 
In a well-researched, methodical argument, the author takes aim at Title VII of the Dodd-Frank Act, which mandates that over-the-counter derivatives be cleared whenever possible, that regulators set margin rules for uncleared OTC derivatives, and that all OTC derivatives trades be reported to data warehouses. Although these provisions are likely to discourage the use of OTC derivatives, he writes, “They are unlikely to reduce systemic risk appreciably.”
 
Professor Tuckman concludes that the key to preventing similar financial crises is not in targeting derivatives trades, positions, and markets in isolation but rather requiring financial institutions to properly manage and disclose their holistic risks – suggestions for which he also proposes.

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Bruce Tuckman is a Clinical Professor of Finance.