In the last 30 years, the financial system has grown far riskier thanks to leverage, the massive use of financial derivatives, securitisation, manipulation of benchmarks and incentives that rewarded excessive short-term risk-taking, among other reasons.
The size of the over-the-counter derivatives market has gone from a USD 70 trillion in the late 1990’s to more than USD 600 trillion today. A market more than 10x the size of the world economy is a threat to society (America’s largest insurance company AIG had to be bailed out after a small team in its London office suffered tens of billions in derivatives losses).
Financial derivatives are useful as hedging instruments but the world’s GDP does not need to be insured more than 10 times. No wonder some people have called derivatives ‘financial weapons of mass destruction’…
In addition, the ‘over-the-counter’ nature of many derivatives contracts makes things worse: it is almost impossible to know which firm is exposed to which risk when OTC contracts are not centrally cleared, or whether there is enough ‘collateral’ to cover the risks.
The securitisation market allows intermediaries to pass on risks to third parties. It is not a bad tool per se but, like the massive use of derivatives, it increases interconnectedness and systemic risk, as we saw with securitised sub-prime mortgages, and needs to be strictly regulated.
Another source of risk is from the manipulation of benchmarks. Many speculators would dream of controlling the prices on which they bet but for some this has become a reality, as we saw with LIBOR (the interest rate benchmark) and other similar scandals. With multiple indices in place affecting the price of trillions worth of financial assets, any manipulation systematically benefits the most influential players, to the detriment of institutional investors and ordinary consumers. Commodity price can also be manipulated by taking speculative positions in commodity derivatives or by directly buying physical commodities and storage facilities. The manipulation of financial indices and of commodities prices has to end.
Finally, bonuses and other employees' incentives are said to have encouraged excessive risk-taking and discouraged proper oversight from senior management.