Summary and Conclusion

We examined the impact of derivatives markets on asset management and the economy through three transmission channels: (1) the volume channel, (2) the efficiency channel, and (3) the risk channel. At the outset of our analysis was the question, whether the growing importance of derivatives changed the financial sectors’ ability to support economic growth and development. After all, certain empirical studies with recent data (e.g. Rousseau and Wachtel, 2006) could not reconfirm the positive finance-growth-nexus typically found in the classical studies on older data (e.g. King and Levine, 1993). What has happened? Have financial markets become more crisis-prone? Or has the advent of derivatives changed the structure and thus conduct and performance of the financial sector and asset management?

166 Summary and Conclusion

In analyzing these questions, we contribute to the literature by (1) introducing derivatives within the context of the finance-growth-literature; (2) by applying the Merton and Bodie (1995) functional framework to discussing the spheres of derivatives influence, (3) by delineating the volume, the efficiency and the risk channel, and (4) by providing descriptive and comparative evidence.

With regard to the impact of derivatives on the finance-growth-nexus, we argue that their huge volumes are clear sign that funds are drawn in from the real side of the economy, while at the same putting these to more productive use within the financial sector via the efficiency channel; given that markets are sub-perfect, these flows add a certain dose of risk to financial markets, at least at times. The true question, however, is: what is the alternative to derivatives?

To sum up in more detail: we find that the exchange traded segment and the over-the-counter segment have experienced strong growth rates during the period 1998 to 2006. Especially the OTC traded segment faced enormous growth rates during the period suggesting that market participants honor the unregulated character and the flexibility of this segment. A comparison of exchange traded derivatives with bank assets, equities, bonds and the GDP in North America shows that the derivatives sector is by far the biggest financial sector in North America, amounting to nearly 300% of GDP. Taking OTC-traded derivatives into account the size of the derivatives sector exceed

“traditional” financial sector even more clearly. Compared to market liquidity indicators (cash, minimum reserves, broad monetary aggregates) derivatives account for more than 8 times the global GDP and represent the majority of global liquidity. Given the huge derivative amounts outstanding it seems that derivative markets have decoupled from other financial sectors and the real economy.

Interpreting descriptive data shows that certain derivatives sectors have become international. Whereas equity-linked derivatives still seem to have a national focus, government debt derivatives already decoupled from national development and turned into a regional phenomenon in Europe.

Liquidity became a “critical success factor” and forced derivatives exchanges to provide highly liquid government debt derivatives in Europe. OTC-traded derivatives have decoupled from national or regional markets long ago and represent the most internationalized derivative segment.

Derivatives have become a common instrument for a broad range of users, particularly financial institutions, asset managers and corporations. In allowing speculation, arbitrage and hedging, and in making the markets more complete,

167 Summary and Conclusion

derivatives have been identified as useful instrument to foster the efficiency of financial markets and economic growth. In allowing the flow of funds and risk sharing among national systems with different institutional shapes and sizes derivative instruments function as “adapter” for the integration of the markets.

Especially asset managers regarded derivatives increasingly important for their activities and named hedging as by far the most important use of derivatives, followed by overlay and cash management strategies.

Given the size, the concentration, and the oligopolistic structure of the derivatives markets, we have highlighted certain risks (market, liquidity, and credit-risk) that have to be evaluated differently from market participants.

As the LTCM case and the subprime-securitization crisis showed, financial institutions and asset managers have to draw more attention to risk controlling and transparency to better assess certain risks associated with derivatives. Due to the fact that derivatives markets are characterized by a huge accumulation of assets and a highly concentrated market structure, we should be prepared for low probability but highly costly downturns. So stress testing is key for asset management and for analyzing counterparty risk. To analyze the impact of derivatives on financial market performance, further quantitative analysis is necessary, including the alternative of “no derivatives”.

168

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