Evolution and intelligent design: developing the derivatives infrastructure

Abstract

Derivatives have transformed the financial markets over the past 25 years, creating innovative ways to manage risk. New products, many of which are variations on existing products, are regularly created. Market participants have used derivatives to address interest rates, exchange rates, equity and commodity exposures since the early days of the derivatives business. More recently, credit, weather, property, inflation and other derivatives have been added to the tool kit for parties looking to mitigate a range of risks that previously were difficult or impossible to manage. The incredible product evolution over the past 25 years would not have been possible if the infrastructure that supports derivatives has not also evolved. As an entirely new form of contract, legal concepts had to be borrowed, adapted or created to form a foundation for this new business. While never done on stone tablets, early derivatives documentation could be nasty and brutish, but not short, and it was necessary to bring order to that chaos. Observers of the growth of derivatives have constantly tried to fit this new and different peg into traditional and more familiar holes. The fundamental logic of the product, which originally facilitated more effective borrowing, has been applied to a range of underlying products and risks. As volumes grew, pressure points developed in the processing of derivatives, the so-called middle and back office, creating the need for evolution in those areas as well.