I view derivatives as time bombs, both for the parties that deal in them and the economic system.
Warren Buffett (1930–) (quote from 2002)
The causes of the global financial crisis (GFC) were complex and related to a mixture of macroeconomic events, government policies, the relaxation of lending standards by financial institutions and the failure of regulation. However, many attach the most significant amount of blame to the very existence of over-the-counter (OTC) derivatives.
In 2008, the global derivatives market reached a total notional of over seven hundred trillion US dollars (Figure 2.4). Around nine tenths of this amount was over-the-counter (OTC), dwarfing exchange-traded products. In hindsight, this has been viewed as creating a dangerous mix of complexity, leverage and interconnectedness. This is perhaps epitomised by the rapid growth of credit derivatives during the period leading up to the GFC.
Another problem was that banks trading the majority of these OTC derivatives were very large as a result of a period of mergers and takeovers. Examples include Citigroup (Citicorp, Travellers Group, Smith Barney, Salomon Brothers), J.P. Morgan Chase & Co. (Chase Manhattan, Bank One), and Royal Bank of Scotland (ABN AMRO). Furthermore, other large financial firms, notably American International Group (AIG), had effectively become very exposed to the OTC derivatives ...