Derivatives have two major functions: risk management and leverage. However, there is a gap in understanding or even misunderstanding about their usage, even among large institutional investors, often between the board and the investment staff. The 2008 global financial crisis drew a dividing line in financial market practices. Some investors since shunned assets that had any structural complexity. Indeed, there was a reduction in derivatives transaction volume in the first couple of years after the financial crisis, due to the risk-off environment. In 2010, dollar derivatives were only 40 percent of the cash market. But by 2016, it had jumped to 150 percent, gold futures went to 160 percent of the physical gold market, while U.S. equity derivatives rebounded to nine times the S&P500.
The rapid recovery was partly attributable to the role of clearing houses, which manage counter-party risk. New regulations also helped institute good practice around safeguards. Ultimately, however, it was investors' migration from over-the-counter (OTC) derivatives to listed derivatives that turned the tides. Investors have cast their votes between "standardized but very liquid" versus "perfect hedge but highly illiquid." In addition to risk management, derivatives also allow investors with specific views on specific parts of the market to gain cheap factor risk exposure.
For institutional investors that are thinking about building in-house derivatives execution capacities, there are four decision factors that they may wish to consider: 1. Need: determine the true reason for having this capability, be it for hedging, managing exposure, or adding liquidity during transition or rebalancing. 2. Selection: choose the right instrument, such as OTC vs. listed; and understand the trade-offs between liquidity, execution cost, and compliance, etc. 3. Readiness: build readiness at the people, process and platform levels. 4. Experience: hire people with experience in related technologies, regulations, and governance.
Will the Liberal International Order Survive Without a Dominant Superpower?
The liberal international order is defined as a world in which liberal nations, specifically the U.S. and its allies, enforce a rules-based system that encourages democracy, open markets, and international institutions. The question at hand is whether this liberal international order can survive if the U.S. is no longer overwhelmingly dominant, economically and militarily, on the world stage. Whether there is an intent or not, China already poses a threat to this U.S.-led order.
Many believe that the liberal international order has secured a period of relative peace and prosperity, ushering in trade and democracy. However, the liberal international order has also created burdens on countries in its crusading effort to spread democracy. For example, despite the image of peace and prosperity, the U.S. has been at war in two-thirds of the years since the fall of the Soviet Union. America’s deeply flawed efforts at regime change in the Middle East, in particular, has negatively impacted millions of lives.