Derivatives: Are They Weapons of Mass Destruction?

Abstract

The growth of the amount of financial derivatives during the last fifteen years has been phenomenal. With the total notional amounts outstanding on over-the-counter derivative contracts amounting to around nine times global GDP by the end of June 2012, they represent by far the largest financial transaction in the world. Even though, these instruments are used to deal with the inherent risk associated with finance, they can be the cause of destruction if not used cautiously. As once pointed out by Warren Buffet, “Derivatives are financial weapons of mass destruction”. In this context, after an analysis of the nature and the types of derivatives, the article seeks to evaluate whether these financial instruments, derivatives, are in fact a cause of financial destruction than a cause which brings forth financial benefits, with reference to several controversial derivative disasters. This doctrinal research was conducted through the traditional black letter approach and the critical analysis method. Qualitative data were gathered through a review of primary sources, statutes and secondary sources, books with critical analysis, research journals, working papers, corporate and policy reports and web sources. In the light of the derivative disasters, 2008 global recession, it is concluded that Buffett‟s statement was correct to a great extent since derivatives are financially lethal in the absence of an effective risk control mechanism. However, it is stated that these derivative disasters could have been prevented with the presence of proper regulations, adequate corporate internal control systems and also with a sound understanding of the nature of the derivatives one deals with.