REGULATING DERIVATIVES: OPERATOR ERROR OR SYSTEM FAILURE?
| Date | 01 January 1996 |
| DOI | https://doi.org/10.1108/eb024864 |
| Published date | 01 January 1996 |
| Pages | 17-35 |
| Author | ATUL K. SHAH |
| Subject Matter | Accounting & finance |
REGULATING DERIVATIVES: OPERATOR ERROR OR SYSTEM
FAILURE?
Received: 10th October, 1995
ATUL K. SHAH
DR ATUL SHAH
IS
LECTURER,
UNIVERSITY OF BRISTOL
AND VISITING ASSISTANT
PROFESSOR,
UNIVERSITY OF MARYLAND. THIS PAPER
WAS PRESENTED AT THE BRISTOL
ECONOMICS WORKSHOP AND THE
WASHINGTON ACCOUNTING RESEARCH
SEMINAR HELD AT THE UNIVERSITY OF
BALTIMORE
IN APRIL 1995. DR SHAH IS
GRATEFUL TO THE PARTICIPANTS FOR
THEIR COMMENTS. HE WOULD ALSO
LIKE
TO THANK HIS RESEARCH
ASSISTANT DONAL
BYARD
FOR HELP IN
THIS PROJECT. IN ADDITION, LEMMA
SENBET AND ANTHONY HOPWOOD
PROVIDED HELPFUL COMMENTS ON
EARLIER VERSIONS OF THE
MANUSCRIPTS. THE AUTHOR CAN BE
CONTACTED AT UNIVERSTIY OF
BRISTOL, DEPARTMENT OF ECONOMICS.
8 WOODLAND ROAD, BRISTOL BS8 ITN,
TELEPHONE +44(0)117 9288438, FAX
+ 44(0)117 9288577.
ABSTRACT
In the wake of
substantial losses suffered
by derivatives dealers and end users in
recent years, questions are being raised
about the
type
of
regulatory structure
nee-
ded to
monitor
and
control
the use of der-
ivatives. Financial institutions believe
that the issue can be resolved by tighter
internal controls, whereas regulators
believe there is a need for more direct
oversight. The conventional view is that
derivatives are highly useful instruments
which simply need to be handled with
care. In this
paper,
it is argued that this
belief is
misplaced
and, although useful
for hedging, derivatives are a high risk
technology which pose
inherent
difficulties
for regulation and
control.
As
suggested
by
Perrow,
where
the
environment
of such
technologies
is both complex and tightly
coupled,
such that any
significant
failure
cannot be contained, the potential for
catastrophe
is significant.1 The foregoing
analysis shows
that
derivatives operate
in
17
JOURNAL OF FINANCIAL REGULATION AND COMPLIANCE • VOLUME FOUR NUMBER ONE
— SHAH —
a complex and tightly coupled environ-
ment, posing a significant threat to the
financial
system.
Regulatory reform would
require
much greater
cooperation between
regulators and a proactive approach to
regulation rather
than a
reactive
one.
INTRODUCTION
By any measure, the derivatives
industry has snowballed in recent
years.
Its aggregate size has grown
from virtually nothing in the 1970s to
trillions of dollars today.2 Alongside
its exponential growth have emerged
problems, especially related to their
technical complexity and riskiness.
Companies who invest in derivatives,
and banks who trade in them, have
experienced substantial losses arising
from derivative transactions.3 Regula-
tors have expressed concern about
the growth in use of these instru-
ments and their inherent riskiness. In
particular, there has been a wide-
spread weakness in the internal con-
trol and risk monitoring mechanisms
established by the banks and securi-
ties houses who deal in derivatives.4
This is a cause of great concern
owing to the tightness with which
modern Financial markets are inter-
linked and the likelihood of a dom-
ino effect and systemic collapse.
There is little doubt that one of the
central advantages of derivatives lies
in their ability to provide corpora-
tions with opportunities to hedge a
wide range of financial and commer-
cial risks. Dolde, in a survey of US
Fortune 500 companies, found that a
sizeable proportion of the firms use
derivatives to hedge their exposures,
although the hedges were rarely per-
fect.5 It is possible that the nonre-
spondents to the survey use
derivatives for speculative purposes.
Hentschel and Smith argue that
owing to the low degree of specula-
tion, the systemic risk concerns are
exaggerated. Derivatives help cor-
porations to pass on shocks and risks
to those who are better able to man-
age these risks. However, Hentschel
and Smith do concede that systemic
risk concerns are real if the external
shock has a long duration, as
happened during the October 1987
global stock markets crash. They
recommend that great care be exer-
cised in designing regulatory systems.
In their view, such systems must not
discourage the positive use of deriva-
tives in any way, or those who are
careful in their handling of derivative
transactions.6
What is striking is that the litera-
ture is fundamentally introspective —
it is dominated by economists and
banking and finance specialists. This
paper departs from this approach by
drawing on the research and experi-
ence of the regulation of other high-
risk industries and technologies, in
addition to the conventional litera-
ture.
It examines the extent to which
the evidence and concerns relating to
derivatives are similar to these exper-
iences. In particular, the work of Per-
row and his theory of 'Normal
Accidents' in complex and high-risk
industries is examined.7 The findings
suggest that this theory has tremen-
dous value in understanding the
issues surrounding the regulation of
derivatives, and in suggesting
possible solutions. Thus this study
adds to the relatively sparse literature
on an issue of major public concern.
Regulators have expressed concern
over derivatives, but thus far have not
taken any significant corrective
actions, partly because of the speed
with which Financial innovation has
taken place. Phillips, a governor of
the Federal Reserve System,
18
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