Does the Institutionalization of Derivatives Trading Spur Economic Growth?

Abstract

It is a widespread view that derivatives played a crucial role during the recent financial and economic crisis. This opinion manifested in headlines such as “Why Derivatives Caused Financial Crisis” and derivatives have been termed “Financial Weapons of Mass Destruction”. However, the analysis of the role of derivatives in the economy requires a much more differentiated discussion as the statements given above imply. In this paper we analyze the effect of institutionalization of derivatives trading on economic growth and economic growth volatility; measuring growth in GDP per capita. The relationship between the institutionalization of derivatives trading and economic growth is investigated by using a panel data set comprising of 45 countries observed over 39 years. Our results show a statistically and economically significant positive effect of the establishment and existence of a domestic derivatives exchange on economic growth. These results are robust to different model specifications and to controlling for financial reforms. The effect of institutionalized derivatives trading on growth volatility is analyzed by means of an EGARCH model and is found to be negative and significant.