By: Damon Aitken
How Financial Instruments Can Aid Development
Derivatives are financial instruments that derive their value from another asset or from any underlying variable. These variables can be anything from the cash flows underlying a painter’s works to the exchange rate of a currency. Some financial literature claims derivatives originated in the 1970s; in reality, the basic concept has been around since antiquity. Commodity traders in Mesopotamia agreed on simple contracts to borrow products and repay the loan at a set value after a certain amount of time. Derivatives have been maligned as a contributor to the financial crisis of 2008, but when managed properly, they may well play vital roles in economic development and the emergence of markets. They have a long history but have shot to prominence in the modern era. Today, the global derivatives market has a value estimated between $542.4 trillion to $1.2 quadrillion– 10 times the world’s GDP. However, much of this value is contained in the markets of high-income countries.
Derivatives mitigate risk by allowing for fluctuations in value. For example, one of the most common forms of a derivative is the currency swap. Currency swaps allow firms to make efficient transactions and maximize profit without losing money during exchange. On the international investment side, risk from exchange rate fluctuations is removed and foreign firms can receive local currency to finance local investments. Below is a demonstration of how a currency swap works and benefits both firms. Firms can take advantage of less favorable lending conditions in their home markets and reduce interest paid on loans.
Low and middle-income countries often face unstable capital flows. Firms lack access to finance to grow and expand. Banks are often ill-equipped to provide loans and incoherent central bank policy can lead to currency shortfalls. Capital markets stimulate investment and contribute to economic growth by allowing firms and governments to raise capital. Capital is essential for economic growth, particularly in developing countries, as it allows firms to materialize, providing employment and wages for workers. Capital allows agents in the economy to carry out essential functions in this manner. Financial instruments essentially can boost the creation of capital. A lack of derivative markets in developing countries can make them unattractive to global investors, and as derivatives increase continue to gain prominence, developing countries may get left in the financial dust. Empowering financial firms in emerging markets involves developing robust financial instruments in those markets.
Derivatives are increasing in use in emerging markets around the world. Commodity futures are a simple yet effective way to ensure against seasonal shortfalls in agricultural production. They were the most-traded type of derivative in 2016. Currency swap derivatives dominate in emerging markets. Currency derivatives tend to be traded in New York, London, Hong Kong, or Singapore. Instruments from a country will usually trade close to that country’s time zone so Latin American instruments generally trade in New York, European instruments generally trade in London, and Asian instruments generally trade in Hong Kong or Singapore.
Markets to Watch
A pan-regional African commodities exchange has tremendous potential as African countries have strong commodity reserves. However, many African countries lack the necessary prerequisites to set up exchanges on their own. A regional or continental initiative could be effective since it would have greater financial backing. There have been efforts to use mobile apps (Sangonet in the DRC, KACE in Kenya, etc.) to connect buyers and sellers in an informal exchange but this suffers from high inherent risk since there is no guarantee of payment. This risk would be less present in an organized exchange setting where the exchange’s clearinghouse provides insurance (page 22 in AfDB guidebook).
It must be noted that while derivatives can be effective in raising capital in developing countries, care must be taken. Countries without strong financial systems in place will most likely be unable to successfully accommodate a derivatives market. A lack of liquidity is a major barrier. Derivatives also rely on the use of borrowed money to finance investment, also known as leverage. This means that investment has the potential to fluctuate large amounts. In cases of economic downturn and instability, investors will be reluctant to commit financial resources. The financial and political stability necessary for truly strong derivative markets precludes many unstable low-income countries from being able to trade these financial instruments.
Policymakers in developing countries hoping to build strong derivatives markets and strong capital markets in general must focus on sufficiently training market professionals to understand the associated risks. They must also pursue policies which help to mitigate these risks and encourage participation in derivatives markets, in order to provide the entire economy with crucial financial instruments. There is also room for public-private partnerships, in which the government creates a strong regulatory environment to prevent mismanagement and private firms lend their expertise, such as high-speed trading computers.
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Bloomberg. (2017, September 27). As MiFID Jolts Derivatives, Hong Kong Eyes $483 Trillion Market. Retrieved from https://www.bloomberg.com/news/articles/2017-09-28/hong-kong-courts-483-trillion-derivatives-market-as-mifid-looms
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