Derivatives are also playing a momentous role in market dynamics. During the boom, faith in central bank backstops promoted risk-taking. Why not revel in risk so long as derivative market “insurance” is so cheap and readily available? This whole notion of hedging market risk is a dangerous case of “fallacy of composition.” Individual market participants can hedge market risk, offloading exposure to a counter-party in the event of a significant market decline. However, it is not possible for much of the market to offload risk. There will be no one within the marketplace with the wherewithal to absorb such losses in a crisis environment.
http://creditbubblebulletin.blogspot.com/2020/05/weekly-commentary-global-bubbles-are.html
Much of the market protection these days is offered by sellers using dynamically-traded (“delta”) hedging strategies. If an institution purchases put options that strike below current market levels, the sellers of those puts will short futures or ETFs to hedge their rising exposures in the event of a declining market. As was witnessed in March, a market fall can quickly spiral into illiquidity and self-reinforcing dislocation – as writers of market protection flood the marketplace with sell orders (to hedge put option exposures that rise parabolically as strike prices are reached and these options trade “in the money”).
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