The explosive growth of derivative products in the last fifteen years has paralleled the growth of cross-border gross capital flows. The use of derivative products has been a major factor in the growth of cross-border capital movements for several reasons. First, by allowing the separation of various risks associated with cross-border investment, it makes such investment more attractive. Portfolio diversification becomes more likely, with a consequent increase in gross international flows. Moreover, impediments to movement of capital in search of higher real yields weaken, with a consequent increase in net flows. Various dimensions of risk can be moved across borders to markets that find them less unattractive. Indeed, such potential gains in the efficiency of the international allocation of capital has redefined a major, profitable segment of the international wholesale banking market.
The problems associated with the rise of derivatives stem partly from the same source as the benefits: the increased ability to separate and market risks means that some counter parties can assume riskier positions more readily than in the past. Coupled with the existence of weak financial systems and the inherent opaqueness of derivative positions due to obsolete accounting systems, slow reporting, and unprepared supervisors, derivatives can be used to leverage financial safety nets in efforts to double up lost financial bets.
Often, such activity must move offshore to evade detection and naturally generates a gross international capital flow. Moreover, derivatives can be used readily to evade onshore prudential regulation and capital or exchange control, thereby generating yet more measured capital flows.
Interpretations of the causes and dynamics of the sudden capital flow reversals associated with balance-of~payments crises generally are based on on-balance sheet information. In the presence of derivatives, however, such data can generate false inferences about the sources of a crisis and lead to misinformed policy prescriptions. They confound the sources of the crisis: whether it stems from foreign speculators, panicked green-screen traders, or domestic insiders armed with knowledge about weak fundamentals. In addition, in the presence of large volumes of derivatives, claims that crises are generated by such inappropriate polices as an excessively short maturity of the public debt can be mirages of on-balance sheet accounting.