Business Funding

The participants of the financial derivative are divided into 2 groups; dealers and the end users.  As the end users, the bank makes use of the derivatives in order to take positions either as a part of their hedging activity for the asset or liability management or for the proprietary trading.   As the dealers, the banking institutions use the financial derivatives by quoting the bids and the offers and commit the capital to satisfy the customer’s requirements for management of risk.

When the financial derivatives were developing, the dealers most importantly acted as the brokers and were finding the counter-parties with the offsetting requirements.  Later the dealers started offering themselves as the counter-parties to the customer’s intermediate needs.  Once this position was taken, the dealer either immediately matched by entering in the opposing transaction or simply warehoused the same.  In this case, the dealer will temporarily uses the futures market for hedging the undesired risks until the match can be found.

The present scenario is completely different.  Nowadays the dealers manage the portfolios of the financial derivatives and supervise the residual or net risks of their position on the whole.  The recent development has completely changed the risk management focus from the individual transactions to the portfolio exposures.  It has significantly enhanced the ability of the dealers to accommodate a wide spectrum of the customer transactions.

As most of the active financial derivative player’s trade on the portfolio exposures, it actually seems that the financial derivatives don’t wind the markets tightly together   than the loans do.  The financial derivative players don’t match each trade with the offsetting trade, but continuously manage the residual risks of portfolio.  In case, if the counter party defaults on the swap, then the defaulter party doesn’t turn and default on another counter-party that offsets the actual transaction.

Instead the default of the derivatives is quite similar to the default of the loan.  That is the main reason why it’s so important that the financial derivative gamers execute with reasonable care and due diligence for determining the default risks of the potential counter parties and the financial strength of the counter parties.

For the banking supervisors in United States, the question that is important in the present scenario is –   what could be the mistake that could possibly endanger the systematic risks?  The danger posed is that one bank failure could actually cause the domino effect, which can precipitate the bank crisis.  As these financial derivatives permit different risks to be passed and isolated in a financial system, and those who are in a position and are willing to take the risks at minimum costs will become risk holders.  This will in turn, substantially reduce the risk bearing costs and will also enhance the economic efficiency.

Also, in absence of the financial derivatives, there will be a jolt in the financial markets and the financial market will be severely affected in cases where the derivatives were freely used.    As the holders of different type of risks actually would be different, there will be a different impact and it won’t be as severe as the risk holders are in a better position to bear the potential losses.