Over-the-counter derivatives were at the epicenter of the global financial meltdown, with even the legendary Warren Buffet describing them as financial weapons of mass destruction.
The hullabaloo over these products would lead us to believe that derivatives are pioneering financial instruments and contemporary creations. The reality is, of course, that derivatives have been around for centuries. The writings of Aristotle present evidence of derivatives trading occurring as far back as 600 BC.
OTC derivatives are contracts executed outside a regulated exchange and allow participants to custom-tailor products to offset business and financial risks. These products are more complex and opaque than exchange-traded derivatives and can significantly increase systemic, operational and counterparty risk.
History is loaded with numerous examples of crises that have been triggered by derivatives trading – in many cases, a consequence of using them for speculation rather than hedging.
During the Dutch Tulip Mania of 1637, for instance, a huge bubble formed as trading in tulip bulb futures exploded, sending prices to extraordinary levels until a shocking collapse that left many investors in penury. More recently, the trading of exotic derivatives has been linked to the transmission of the financial crisis from the U.S. and Europe to many other parts of the world.