Deriving the Economic Impact of Derivatives Growth Through Risk Management March 2014 Deriving the Economic Impact of Derivatives Growth Through Risk Management Apanard (Penny) Prabha, Keith Savard, and Heather Wickramarachi Research Support Stephen Lin, Donald Markwardt, and Nan Zhang Project Directors Ross DeVol and Perry Wong March 2014 ACKNOWLEDGMENTS This project evolved from discussions with various stakeholders of the Milken Institute who encouraged us to examine derivatives markets in the aftermath of the financial crisis and Great Recession. It was made possible through the support of the CME Group. The views expressed in the report, however, are solely those of the Milken Institute. The Milken Institute would like to give special thanks to the research department of the CME Group for their valuable suggestions, feedback, and overall leadership throughout the research process. The authors appreciate the indispensable efforts of Milken Institute Managing Director Mindy Silverstein in securing the resources required to convert a methodological outline into a final product. Additionally, we appreciate the encouragement provided by Milken Institute CEO Michael Klowden in this undertaking. The Milken Institute Research team is grateful for the advice, counsel, and expertise provided by reviewers Richard Sandor, chairman and CEO of Environmental Financial Products LLC; Ross Levine, Willis H. Booth Chair in Banking and Finance at the Haas School of Business, University of California at Berkeley; and James Barth, the Lowder Eminent Scholar in Finance at Auburn University. All are Senior Fellows of the Milken Institute. Richard Sandor is a true financial innovator known as the “father of financial futures.” Ross Levine is among the most highly regarded researchers in the operations of financial systems and functioning of the economy. Jim Barth is an expert in financial institutions and capital markets, both domestic and global, with special emphasis on regulatory issues. Our colleagues’ insights significantly improved the quality and clarity of this report. LoremABOUT THE MILKEN ipsum INSTITUTE dolor sit amet, consectetur A nonprofit, nonpartisan economic think tank, the Milken Institute works to improve lives around the world by advancingadipiscing innovative economic elit. and Praesent policy solutions that pharetra create jobs, widen accessvestibulum to capital, and enhance lacus health. We produce rigorous, independent economic research—and maximize its impact by convening global leaders from theeget worlds ofconsequat. business, finance, government, In vel and philanthropy.varius Bymetus. fostering collaboration Curabitur between the public ut and fringillaprivate sectors, we transformest. Sed great ideas hendrerit into action. mollis facilisis. ©2013 Milken Institute This work is made available under the terms of the Creative Commons Attribution-NonCommercial-NoDerivs 3.0 Unported License, available at creativecommons.org/licenses/by-nc-nd/3.0/ —Lorem Ipsum Contents Executive Summary ...................................................................................... 1 Key Findings ...................................................................................................................... 1 An Empirical Foundation .................................................................................................. 2 Derivatives: A Market Mainstay Amid Globalization ....................................................... 4 Why Use Derivatives? ....................................................................................................... 5 Regulatory Reform and the Future .................................................................................. 6 Introduction ................................................................................................... 9 1. History ...................................................................................................... 13 1.1 Integration and Oversight in the Modern Era ........................................................... 14 2. Global Growth and Recent Trends ....................................................... 19 2.1 Volatility and Technology ..........................................................................................22 2.2 The Exchange-Traded Market .................................................................................. 25 2.3 The OTC Market ......................................................................................................... 27 2.4 Different Environments, Different Strengths ..........................................................30 3. Risk, Price, and Cost ............................................................................... 33 3.1 Managing Risk ...........................................................................................................33 3.2 Price Discovery .........................................................................................................40 3.3 Liquidity and Lower Costs ........................................................................................42 4. Measuring Derivatives’ Impact Empirically ....................................... 45 4.1 Bolstering Bank Lending .........................................................................................48 4.2 Augmenting the Value of Non-Financial Firms .......................................................55 4.3 Overall Impact on the U.S. Economy ........................................................................ 59 4.4 What Futures Do for the Economy ...........................................................................63 5. A New Framework .................................................................................. 69 5.1 Clearing and Capital .................................................................................................. 69 5.2 Costs Will Influence Use ........................................................................................... 71 5.3 Extraterritoriality and Regulatory Arbitrage .......................................................... 71 References and Appendixes ....................................................................... 73 About the Authors ..................................................................................... 104 Executive Summary This study is being released at a time when the global economy is still struggling to heal itself, with the help of central banks, from a crisis that ravaged the financial system. Prior to the calamity that began six years ago, derivatives use grew at an astounding rate as a broad array of businesses and investors sought to reap their benefits. During the period of the crisis and its aftermath, over-the-counter (OTC) derivatives—credit derivatives in particular—were severely criticized as a factor in raising counterparty risk and contributing to a near-shutdown of the financial system. Consequently, significant regulatory change has been instituted with the aim of increasing transparency and reducing systemic risk. It is time for a fact-based assessment of the role derivative products play in commerce. If these financial instruments are so harmful, as some parties believe, why do so many banks and non-financial firms use them in the course of everyday business? What has been lost in the drama surrounding derivatives is an understanding of the positive impact, primarily through risk mitigation, that most of these instruments have had on U.S. economic growth over the past decade. KEY FINDINGS » Banks’ use of derivatives, by permitting greater extension of credit to the private sector, increased U.S. quarterly real GDP by about $2.7 billion each quarter from Q1 2003 to Q3 2012. » Derivatives use by non-financial firms increased U.S. quarterly real GDP by about $1 billion during the same period by improving their ability to undertake capital investments. » Combined, derivatives expanded U.S. real GDP by about $3.7 billion each quarter. The total increase in economic activity was 1.1 percent ($149.5 billion) between 2003 and 2012. » By the end of 2012, employment had been boosted by 530,400 (0.6 percent) and industrial production 2.1 percent. Derivatives’ role during the financial crisis and subsequent anemic recovery is also examined. Derivatives are shown to have an even larger positive impact relative to the pre-crisis period. This is not surprising given that firms use derivatives to minimize cash-flow volatility associated with underlying risk. This first-of-its-kind study of derivatives’ quantitative impact on economic growth is built on a solid and robust methodological foundation, an extensive literature survey, and careful attention to data gathering and empirical analysis. Several methodological challenges were overcome in attempting to discern the effects of derivatives use on overall U.S. economic performance. 1 Case studies of the airline, energy, and food-processing industries provide detail and context for the macroeconomic analysis. As reported in 10-K filings, many firms in these industries saved hundreds of millions of dollars in costs or enjoyed other net gains through derivatives use during the course of a fiscal year. Their choice of instrument varies from forwards to futures and options as well as swaps. Companies that use these derivatives report their impact on pricing, output, supply chains, and other factors. Considering the scale of the derivatives market, while the notional value (the value of the contracts’ underlying assets) of OTC derivatives