The Role of the Derivatives in Credit Default - Essay Example

This is known as the ability of derivatives to soar 100 percent within a few days, when the security has risen to by a small percent of 10 percent. Derivatives are also used to control large blocks of stocks for a much lesser sum that would be required for the outright purchase (Carter, 2009, p. 67). This means that derivatives give people the ability to control and manage risk. As supervisors of banking, the central bank are concerned that commercial banks’ participation in derivatives markets could lead to a major bank default that could be worsen and lead to the disruption of financial markets.

Default on any derivative or financial contract involves the failure by one party to the contract to make a payment under the required contract agreements. For derivatives, default occurs when two conditions are met in a simultaneous manner. In this case, a party to the contract is in debt under the contract terms, and the counterparty cannot obtain the money within the given period (Hanson, 2010, p. 58). No regulation of the derivatives can work well if there is no strong mandatory mechanism that would expose raw data to the regulators in policing the market for misuse.

Credit derivatives are the causative factors that led to the overwhelmed financial markets that led to the recession. Due to deposit insurance and the reluctance of the government to let the banks, the credit risk is transferred to the government which is the turned onto the tax payers. The bank depositors who are the main stake holders have no incentive in monitoring the banks’ risk exposure. This move will allow the banks to load up on risk without attracting additional capital. This means that unregulated credit derivatives will offer unprecedented leverage.

Since finance markets are a true reflection of a true economy, the misuses of the derivatives can have a great impact on it (Teslik, 2009, p. 60). The credit defaults have played a major role in the financial problems that people are faced with. The high volatility and turbulence that financial markets experienced is as a result of their misuse of derivative security. Banks that have been faced with lack of operating capital have been faced with the wrath of fluctuating values in their debt obligation, mortgage backed securities and credit default swaps. 2) What lessons should be taken by the UK’s financial sector and regulators in relation to 'Bear Stearns’ and other high profile cases?

An important lesson that has been learned is the difference between short term and long term liability has been neglected or has been given insufficient attention by regulators. With reference to the liability structure of the U.S banking system, there is a clear majority of short term debts. This was taken in forms of wholesale or deposit funding which included commercial paper or repurchase agreements. Whole sale funding runs were also witnessed through refusal or commercial paper or repo creditors to roll over their loans.

This played a major role in the demise Bear Stearns, Northern Rock and Lehman Brother among other higher profile failure cases. The UK’s financial sector should be able to regulate debt maturity (Kirkpatrick, 2009, p. 78). Another lesson that was learned was that the fire scale risk associated with excessive short term funding does not only originate from depositories, but rather, a financial intermediary with a combination of financing structure and asset choice which may exacerbate a