The Relationship between the Complexity of Financial Derivatives and Systemic Risk

Abstract

During the last decades, a growing number of financial derivatives traded both in- and outside organized exchanges enforced the interconnectedness of participants in financial markets. Traditionally, scholars and practitioners argued, that derivatives allow to transfer economic risks to the market participants best able to bear them and thereby decrease systemic risk. However, this implies the ability to properly assess the inherent risk prior to the acquisition in order to make an informed in- vestment decision. In contrast to the traditional argument for the systemic benefit of risk sharing, this paper argues that the complex design of financial derivatives – characterized by multiple derivation of pooling-based derivatives – increases the potential for a systemic crisis substantially.The argumentation for this relationship between the complexity of financial derivatives and systemic risk starts with an analysis of the decision behavior under uncertainty. In particular, the difference in the perception of (determinable) risk on the one hand, and ambiguity on the other hand builds the foundation of the following argumentation. The next step points out the relevant contractual mechanisms of financial derivatives and their economic consequences: The pooling of risk sets a strong incentive for the issuer to communicate only a part of the valuation-relevant information to third-parties (information destruction effect). The structuring of risk by the principle of subordination causes the relevance of influencing factors on the overall risk structure of the derivative to shift materially. If, finally, these derivatives are once again pooled and structured, the economic effects of estimation errors on the identified value of the derivative of 2nd degree are systematically enforced. The paper concludes, that there will be simply too little information available from a certain (a priori undetectable) level of derivation on, to provide a reliable risk assessment in the light of the material impact of estimation errors. Thus, the multiple derivation of pooling-based derivatives goes hand in hand with enormous operational risk and model risk.As long as decision makers place trust in the functionality of the valuation models and estimation heuristics applied, they are faced with determinable risk. If that trust erodes, they perceive ambiguity – a situation where they feel to lose control, react pessimistically or may even panic. The higher the level of complexity market participants are faced with and the more imperfect the information regarding the risky assets (both shown to be a result of the multiple derivation of pooling-based derivatives), the higher is the level of trust aggregated in financial markets. Trust relations are – from a systemic point of view – informational transmission channels for systemic events: As the accumulated level of trust in economic boom periods turns – after an unexpected shock – suddenly to distrust as a reflex of decision makers to handle the perceived complexity under asymmetric information, decision makers are now faced with ambiguity. Since there is a self-enforcing tendency between distrust, ambiguity and the risk sensitivity, which finally affects the leverage applied by market participants and their demand for risky assets, markets become ultimately illiquid. Moreover, as decision makers do not strictly distinct between different classes of financial instruments, their decision behavior regarding all assets will change (for which they are marginal investors), so that a downward spiral induced by complex derivatives affects other segments of financial markets, too, and finally swashes to the real economy.