Unveiling The Dilemma: Do Financial Derivatives Imperil or Propel Economic Prosperity?

: The study delves into how regulated derivatives trading influences economic growth across 21 countries, spanning from 1995 to 2022, encompassing major economies like the USA, UK, India, Brazil, Canada, and Australia. While derivatives markets are often linked with the 2008 financial crisis, our research explores their potential to positively impact the economy through various pathways detailed in the paper. Employing a dynamic panel data model (GMM) mitigates potential endogeneity concerns. Our findings reveal notable insights: we identify a positive association between the expansion of regulated derivatives trading and economic growth, evident in both percentage change and per capita GDP. Additionally, inflation shows a negative correlation with economic growth, while trade openness and fertility rates exhibit positive correlations. Notably, our study uncovers unexpected outcomes, diverging from existing literature, particularly concerning the relationships involving foreign direct investments, gross domestic savings, government consumption expenditure, and economic growth.


Introduction
During the early 2000s, it became evident that events in the financial sector had tangible effects beyond their immediate realm and could significantly impact the real economy.Financial markets, serving as alternative sources of funding compared to traditional banking systems, gained significance in many developing as well as developed nations.These markets interconnected countries worldwide through intricate and sophisticated instruments, expanding the array of liquidity options available globally.As a result, trillions of dollars were exchanged daily, showcasing the immense scale of financial activity and its pervasive influence on the global economy (Jeronimo et al., 2023).In addition to facilitating payment methods essential for all economic transactions, the financial system serves as a bridge connecting present activities with future production and consumption (Demetriades and Andrianova, 2004).Derivatives exchanges and products play a vital role in today's interconnected global financial markets (Samarakoon et al., 2023).
Despite numerous empirical studies on the causality of finance and growth, academic research inadequately addresses the derivatives market's crucial role in economic growth and its connection to macroeconomic factors.The motivation behind this paper stems from the need to bridge the knowledge gap and provide a comprehensive analysis of how financial derivatives influence economic growth.This research is driven by several key factors.First, there is the growing importance of financial derivatives.Over the past few decades, the use of financial derivatives has expanded significantly.These instruments are not only used by financial institutions but also by corporations, governments, and individual investors to hedge against risks, speculate, and enhance returns.Understanding their impact on economic growth is crucial for policymakers, investors, and regulators.
Second, existing literature offers diverse perspectives and mixed evidence on the relationship between derivatives and economic growth.Some studies suggest that derivatives markets contribute to economic stability and growth by improving market efficiency and liquidity.Others argue that derivatives can increase systemic risk and lead to financial instability, potentially hampering economic growth.This paper aims to synthesize these perspectives and provide a clearer understanding of the underlying dynamics.
Third, there are significant policy implications.The regulation of financial derivatives markets is a contentious issue.Policymakers need robust evidence to design regulatory frameworks that harness the benefits of derivatives while mitigating associated risks.By examining the link between derivatives and economic growth, this paper seeks to inform policy decisions that promote sustainable economic development.
Fourth, advances in technology and market innovations have led to the creation of new derivative products and trading platforms.These developments have transformed financial markets, making it imperative to reassess their impact on economic growth in the context of a modern, technologically advanced financial ecosystem.
Finally, as financial markets become increasingly integrated globally, the effects of derivatives on economic growth extend beyond national borders.Understanding these cross-border implications is essential for coordinating international regulatory efforts and fostering global economic stability.
In comparison with the previous empirical literature, this study stands out for several distinctive features: 1) its focus on 21 major world economies including the USA, UK, India, Brazil, Canada and Australia 2) utilization of a larger volume of available historical data ; 3) implementation of dynamic panel data analysis, enabling the inclusion of more countries, time periods, and variables.
The paper is structured as follows: Section 2 provides a concise review of the literature pertaining to the subject; Section 3 offers a description of the data and used methodology; Section 4 elaborates on the econometric analysis based on panel data and discusses the results; Section 5 outlines the concluding remarks and policy recommendations derived from this research.

Theoretical background
Theoretical and empirical studies have explored the significance of macroeconomic variables in the relationship between financial development and economic growth, particularly within the capital market, which inherently encompasses the derivatives market.Research on the relationship between derivatives and economic growth generally suggests that derivatives can positively or negatively influence economic growth through several mechanisms.Below are some conclusions from studies that identified a relationship between derivatives and economic growth, highlighting the transmission channels of both positive and negative impacts in the background literature (Figure 1).
Derivatives markets have the potential to positively impact the economy through several channels.First, derivatives are used for risk management purposes (Bodnar et al., 1998).Hedging enhances firms value by mitigating the underinvestment constraint.During periods of financial turmoil, management might refrain from investing in projects with positive net present value because the benefits primarily benefit debtholders rather than shareholders (Myers, 1977).This issue of underinvestment can result in a decline in firm value.However, hedging presents a solution by reducing the likelihood of financial distress, subsequently diminishing the motivations for managers and shareholders to underinvest (Bessembinder, 1991).This is accomplished by resolving agency conflicts and addressing information asymmetry, thereby lowering operational expenses, stabilizing cash flows, and reducing financing costs.Conversely, well-functioning derivatives markets provide investors with powerful instruments for managing risks effectively (Sittisawad and Sukcharoensin, 2018).Unlike conventional asset markets, derivatives offer lower entry barriers, expanding access to a broader spectrum of participants.

Figure 1. Transmission channels between derivatives and economic growth in the background literature
Source: authors' computation Furthermore, derivatives bolster liquidity and operational efficiency within financial markets (Chernenko and Sunderam, 2014).These markets enhance the informational efficiency crucial for informed investor decisions, providing valuable insights that drive market dynamics.These financial instruments can improve market efficiency by providing mechanisms for price discovery.By allowing market participants to hedge risks and express their views on future market movements, derivatives contribute to the efficient allocation of resources and capital.Derivative prices serve as valuable information for traders, contributing to the price discovery process and establishment of more stable financial markets.On the other hand, Fama (1970) discusses the role of competition in ensuring market efficiency.Derivatives markets are often highly competitive, with numerous participants trading a wide range of contracts.This competition promotes market liquidity and lowers transaction costs, making it easier for investors to access capital and engage in productive economic activities.
Nevertheless, derivatives facilitate efficient capital allocation and investment (Campbell et al., 1997) and contribute to innovation and market development (Tufano, 2003).Nevertheless, the efficacy of these products varies, necessitating both qualitative and quantitative research to pinpoint the factors that impact their effectiveness (Mugo-Waweru and Yu-Kyung, 2013).
Moreover, derivatives, such as futures contracts, options, and swaps, offer investors opportunities to gain exposure to various underlying assets without directly owning them.For example, investors can use derivatives to hedge against adverse movements in the prices of stocks, bonds, commodities, or currencies.By incorporating derivatives into their investment strategies, investors can achieve greater diversification, manage risk more effectively, and potentially enhance overall portfolio performance (Sharpe, 1992).This diversification benefits not only individual investors but also institutional investors and fund managers, ultimately contributing to the stability and growth of financial markets and the economy as a whole.
Lastly, derivatives facilitate foreign investment and cross-border capital flows.They play a crucial role in international financial markets by providing hedging mechanisms against currency and interest rate risks associated with foreign instruments.By mitigating these risks, derivatives help to lower the barriers to international investment (Claessens and Schmuckler, 2007).
Several authors concentrate on the drawbacks associated with derivatives markets, overlooking the considerable advantages they can provide to firms, investors, and the overall economy.The use of derivatives presents various risks to the financial system and the broader economy.Derivatives can amplify systemic risk within the financial system, leading to widespread instability that negatively impacts economic growth (Acharya et al., 2009).Their speculative use can increase market volatility, causing uncertainty and potential disruptions in economic activities (Stulz, 2004).Excessive use of derivatives has been associated with financial instability, as seen in the 2008 financial crisis, where complex derivative products played a significant role (Brunnermeier, 2009).Moreover, derivatives can heighten credit risk by exposing counterparties to potential defaults and financial distress if obligations are not met (Jarrow and Turnbull, 2000).Additionally, the significant leverage involved in derivative transactions can result in overexposure to financial risks and potential economic downturns during market fluctuations (Gorton and Metrick, 2012).Furthermore, the presence of derivatives may also encourage risk-taking behavior among financial institutions, leading to moral hazard and potential negative repercussions for the broader economy (Rajan, 2006).Lastly, derivatives can sometimes lead to mispricing of assets and misallocation of resources, diverting investments from productive sectors to speculative activities (Froot and Stein, 1998).These factors highlight the importance of effectively managing and regulating derivative markets to mitigate their adverse impacts on economic stability and growth.
The empirical literature on the connection between derivatives and economic growth is relatively scarce.Liu (2021) employs a panel vector autoregression methodology to analyse the dynamic relationship between economic growth and derivatives market.Analysing data from six countries, the study uncovers compelling empirical evidence suggesting that derivatives exert a significant and positive impact on economic growth.Pradhan et al. (2014) undertakes an analysis of interconnected relationships among four economic elements: the banking sector, stocks, economic growth, and macro variables such as foreign direct investment (FDI), trade openness, inflation rate, and government consumption and expenditure.Notably, the financial sector, banking, and derivatives market are identified as drivers of economic growth, while FDI and trade openness appear to stimulate economic activities through both the stock market and the banking sector.More recently, Hong Vo et al. (2020) explore the dynamic interplay among several key variables using recent panel date from 17 countries, covering data up to 2017.Firstly, their research unveils compelling empirical evidence of a two-way causal link between derivatives markets and global economic growth.Secondly, employing advanced statistical methods such as panel vector autoregression, impulse-response analysis, variance decomposition, and panel econometrics, they confirm that trade openness and government expenditure exert stronger influences on derivatives markets than economic growth and inflation.Thirdly, they observe that derivatives markets forge a more direct and intertwined connection with economic growth and broader macroeconomic factors in high-income nations compared to those in upper-middle-income economies.
Earlier economic theories have established a negative correlation between inflation and economic growth (Fischer, 1993;Barro, 1995).These findings appear more robust with increased data frequency.Notably, the most significant results emerge from annual data analysis, while no discernible relationship is observed in cross-sectional data.The findings of Bruno and Easterly (1998) indicate a correlation between inflation and growth only when reaching a certain threshold; notably, growth tends to be significantly negative during times of crisis.In their study, Samsuddin and Amar (2020) investigated the factors influencing economic growth within the G20 (group of 20).Using panel data and employing linear regression alongside the Random Effect Model, they analyzed data spanning from 2013 to 2018.The variables under consideration included economic growth, foreign direct investment, inflation, exchange rates, and total population.Their findings revealed that among these variables, only inflation exhibited a significant and negative impact on economic growth, primarily driven by low inflation.Conversely, the exchange rate, total population, and foreign direct investment were found to have a positive effect on economic growth.
In addition to the factors mentioned, other determinants such as life expectancy, active population size, or research and development (R&D) investment are also considered as determinant variables of economic growth.Initial life expectancy is included due to its correlation with overall health, population size due to the non-rivalrous nature of technological innovation, and R&D expenditure for its direct impact on innovation.Moreover, the changes in the working-age share of population can impact the average standard of living and consequently the GDP per capita growth (Cruz and Ahmed, 2018).According to the Solow model, population growth is expected to negatively affect capital accumulation, while factors like openness and protection of property rights are anticipated to have a positive impact on capital accumulation.Furthermore, the accumulation of human capital is influenced by factors such as the relative size and school enrollment of the young-age population.In our study, we use three measures of educational attainment.
Consistent with the previous empirical literature that investigated the relationship between financial development and economic growth, we will consider also the following control variables: inflation rate (Bruno and Easterly, 1998;Samsuddin and Amar, 2020), population growth (Prochniak and Wasiak, 2017), foreign direct investment rate (Li and Liu, 2005), fertility rate, life expectancy at birth, the share of population aged 15-64 (Cruz and Ahmed, 2018), the openess rate, government consumption expenditure (Prochniak and Wasiak, 2017).

Data and methodology
The dataset comprises 21 countries, from which 15 high income countries, 5 upper middle countries, respectively 1 lower middle country, according to the classification of the World Bank (Table 1).The selection of countries was restricted to those for which the BIS provided derivatives market data.

Country Country classification (World Bank classification)
Below is a comprehensive list of the variables used in the econometric study (Table 2).Except for the derivatives market size data, which was obtained from the BIS, all other variables were sourced from the World Bank's World Development Indicators.Regarding the derivatives data, due to data availability, we assume that if the currency used for trading derivatives is a specific country's official currency, then the country where the derivatives are traded is considered to be that issuing country.After conducting an in-depth review, we develop two empirical models that include the derivatives markets size, economic growth, and various control variables.The regressions specifications are formulated as follows: , =  0 +  1  ,−1 +  2  , +  3  , +  4  , +  5  , +  6  , +  7  , +  8  , +  9 _ , +  10  , +  11  , +  12  , +  , (1)  , =  0 +  1  ,−1 +  2  , +  3  , +  4  , +  5  , +  6  , +  7  , +  8  , +  9 _ , +  10  , +  11  , +  12  , +  , (2) where i represents the number of countries, and t represents the time period. , signifies the annual percentage growth rate of the real gross domestic product (GDP) in country i at the period t,  , is the annual percentage growth rate of GDP per capita,  , denotes the derivatives market notional amounts outstanding (total exchange rate and interest rate derivatives),  , is the inflation rate. , refers to the merchandise trade, the ratio of total exports and imports to GDP, while  , signifies the net inflows of investment. , represents the government consumption expenditure. , denotes the gross domestic savings,  , the research and development expenditure, _ , indicates the population aged 15-64,  , the population growth  , the fertility rate, and  , the life expectancy.The error term is denoted by  , .
We have preferred to use a dynamic panel data analysis (Generalized Method of Moments (GMM)) over traditional panel data analysis techniques due to several advantages it offers in dealing with specific econometric challenges: endogenous regressors, instrumental variables, efficient estimation, and overidentification tests.On the other hand, GMM is well-suited for dynamic panel data models, which are common in growth studies.

Results
Below we present the results of the econometric analysis.Consistent with previous empirical literature, we use a GMM technique to depict the impact of derivatives on the economic growth.Economic growth is assessed by two metrics: the annual percentage growth of the economy (GDP growth) and the percentage change in GDP per capita (GDPC growth) (Table 3).Source: authors' computation The Sargan test was used in evaluating the validity of the instruments.Its p-value was higher than 0.05, indicating that the null hypothesis of valid instruments cannot be rejected.
The results point out some significant relationships between several independent variables and economic growth.
First, the results indicate a positive relationship between the interest variable, the derivatives market and economic growth.This indicates that derivatives, by providing mechanisms for risk management and enhancing market efficiency, can play a significant role in fostering economic development and stability.However, it's crucial to further investigate the causal pathways and potential risks associated with derivatives to fully understand their impact on economic growth.
The negative relationship between inflation and economic growth can be explained by the uncertainty and reduced investment, the erosion of purchasing power, distorted price signals, negative impact on savings, as well as by an increased exchange rate volatility.
The negative relationship found between government consumption expenditure and economic growth could be explained by the crowding out effect.High levels of government consumption expenditure can lead to crowding out of private sector investment.Inefficiency and misallocation (corruption, inefficiencies) or persistent high levels of government consumption expenditure can lead to fiscal deficits and increasing public debt.
The negative relationship found between savings and economic growth can be counterintuitive since higher savings are typically thought to provide the capital necessary for investment, which should spur economic growth.However, several economic mechanisms and scenarios can explain this inverse relationship (paradox of thrift, liquidity trap, high savings rate in context of high uncertainty, demographic factors).In aging societies, higher savings rates may be associated with an older population that saves more for retirement, but savings may not be efficiently channeled into productive investments.
Based on our empirical findings, we observed significant relationships between trade openness and economic growth.Our study revealed that countries with higher levels of trade openness tend to experience greater economic growth.This relationship can be attributed to several factors.Trade openness allows countries to specialize in producing goods and services where they have a comparative advantage, leading to increased efficiency and productivity gains.Access to larger markets through international trade also facilitates technology transfer and innovation, further boosting economic output over time.
While FDI is generally associated with positive effects such as technology transfer, capital inflow, and job creation, there are circumstances under which it can have adverse consequences for economic growth, as suggested by our empirical results.These can include crowding out domestic investment, dependency on foreign investors, income inequality, or weak linkages with domestic economy.
Lastly, the positive relationship between fertility rate and economic growth highlights the dynamic interplay between demographic trends and economic performance in shaping overall societal and economic development.Higher fertility rates within a specific timeframe can expand the labour force, boost domestic consumption, and potentially enhance economic productivity through increased workforce participation and consumer demand.

Conclusions
The positive relationship between derivatives and economic growth suggests that derivatives markets can play a beneficial role in supporting economic development.Policymakers should focus on creating a conducive environment for the growth of these markets while implementing safeguards to mitigate potential risks.They should invest in market infrastructure, such as exchanges, clearinghouses, and settlement systems, to facilitate efficient and secure trading of derivatives.
On the other hand, public policies could aim at promoting financial literacy and education among potential market participants, increasing the understanding of derivatives among investors, businesses, and financial professionals.By promoting financial literacy, enhancing regulatory oversight, encouraging innovation, and fostering international cooperation, governments can harness the benefits of derivatives to support sustainable economic growth.
It is however important to acknowledge several limitations and suggest directions for future research to provide a balanced and comprehensive understanding of the findings.The quality and specific coverage of the derivatives data provided by BIS used in the study may limit the robustness of the findings.Due to data availability, we assume that if the currency used for trading derivatives is a specific country's official currency, then the country where the derivatives are traded is considered to be that issuing country.Reporting biases could therefore affect the results.Moreover, period and regions covered by the study might limit the generalizability of the findings.Economic conditions, regulatory environments, and financial market structures can vary significantly across different times and regions.
Conducting longitudinal studies that track the impact of derivatives over longer periods could help in understanding the long-term effects and potential lagged impacts on economic growth.Nevertheless, focus on firm-level or industry-level analyses to understand how derivatives usage affects business performance, investment decisions, and productivity, thereby contributing to economic growth can be also taken into consideration as further research.