The financial crises faced by newly industrialized economies (NIEs) in the 1990s were significantly different from the foreign debt crises in the developing countries in the previous decade. Different forms of foreign funds flowed to different recipients in developing countries during the two periods. More importantly, derivatives emerged as an integral part of fund flows in the 1990s.

Derivatives played an unprecedented key role in the Asian financial crisis of 1997, alongside the growth of fund flows to Asian NIEs, as part of financial globalization in unregulated global foreign exchange, capital and debt markets. Derivatives facilitate the growth in private fund flows by unbundling the risks associated with financial vehicles, such as bank loans, stocks, bonds and direct physical investment, and reallocating the risks more efficiently by expanding the distribution and the level of aggregate risk. They also facilitate efforts by many financial entities to raise their risk-to-capital ratios to dodge regulatory safeguards, manipulate accounting rules and evade taxation. Foreign exchange forwards and swaps are used to hedge against floating exchange rates as well as to speculate on fixed exchange rate vulnerability, while total return swaps (TRS) are used to capture "carry trade" profit from interest rate differential between pegged currencies.

Structured notes, also known as hybrid instruments, which are the combination of a credit market instrument, such as a bond or note, with a derivative such as an option or futures-like contract, are used to circumvent accounting rules and prudential regulations in order to offer investors higher, though riskier, returns. Viewed at the macroeconomic level, derivatives first make the economy more susceptible to financial crisis and then quicken and deepen the downturn once the crisis begins. Since investors can only be seduced to higher risk by raising the return on higher risk, the quest for high return raises the aggregate risk in the financial system. But investors always demand a profit above their risk exposure which will leave some residual risk unfunded in the financial system. It is in fact a socialization of unfunded risk with a privatization of the incremental commensurate returns.

The private global fund flows that led up to the crises of the 1980s were largely in the form of dollar denominated, variable interest rate, syndicated commercial bank loans to sovereign borrowers, recycling petro-dollar deposits from OPEC trade surpluses. The formation of syndicates to underwrite these loans helped to bind lenders together, and along with cross-default clauses in the loan contracts, it greatly reduced individual banks’ credit risks by passing such risk to the banking system. Loan syndication amounted to a lender monopoly with open price-fixing between previously competing banks.

In order to reduce the banks’ collective exposure to market risk, these loans were issued as adjustable interest rate loans (usually priced as a spread above LIBOR or some short-term interest rate that reflected banks’ funding costs), and they were denominated mostly in dollars or otherwise in other G-5 currencies (which reflected the currency denomination of the lending banks’ funding sources). Foreign fund flows in this form shifted most of the market risk to the borrowers who might not have fully understood that they bore both foreign exchange risk as well as interest rate risk, and the spiraling exacerbating effect of the two risks on each other, i.e., rising dollar interest rates would devalue non-dollar local currencies which in turn would push up local interest rates.

Lending banks in the advanced financial markets of the 1980s, whose liabilities were mostly short-term and denominated in the same currencies as their loans to developing countries, bore little market risk. Their exposure was almost entirely credit risk, and this was substantially mitigated through the syndication of the loans and the inclusion of cross default clauses. Thus a supposedly “free” debt market transformed itself into a bilateral market between powerless individual borrowers and an all-powerful lending monopoly. It was the height of hypocrisy that in an era of blatant financial monopoly that neo-liberal finance market fundamentalism achieved its unprecedented intellectual ascendancy.

The change in the distribution of market risk to Third World sovereign borrowers laid the foundation for the crisis that began in August of 1982. The crisis began when the Federal Reserve raised short-term dollar interest rates to fight US run-away stagflation. Higher dollar interest rates, which served as the basis for payments on adjustable rate loans, both increased the dollar payments on loans and increased the cost in non-dollar local currencies for dollars. Debtor countries were forced to drastically increase their foreign borrowing in order to reduce the burden of servicing suddenly higher foreign debt costs, leading to inevitable crisis.

In August of 1982, the Mexican government announced its inability to make scheduled foreign loan payments. In response, the developing economy governments, major money center banks, and the IMF and World Bank began searching desperately for post-crisis recovery policies, initially by rescheduling existing debt, arranging new lending and requiring the developing economy governments to implement austere fiscal and monetary policies to make possible the eventual repayment of the continuously growing debt burden, but in effect foreclosing developing economies any prospect of growth with which to repay the still mounting foreign loans. The foreign creditors were protected; the debtor developing nations lost what little they had gained in the previous decade and then some, with no prospect of ever escaping from the tyranny of foreign debt in the foreseeable future. Neo-liberal economists cited Shakespeare: Better to have loved and lost, then not to have loved at all, while their paying clients laughed all the way to the bank.

The Asian financial crises that began in 1997 were very different phenomena. They were caused by hot money (short-term foreign credit based on over-valued exchange rates that were defended beyond reason by Third World monetary authorities poisoned by neo-liberal advice). Derivatives trading in over-the-counter (OTC) markets were, and still are, neither registered nor systematically reported to the market. Thus the full risk exposure in the system is not known until the crisis hits. In macroeconomic terms, derivatives have the structural effect of privatizing the incremental efficiency (profits) while socializing the risk (losses) associated with such profits. This is done by extracting value through rising risk/return ratios by siphoning off part of the incremental return to known private parties while passing on the full incremental risk to faceless third parties spread throughout the system. Since the spread was minuscule, profit incentive pushed for massive increases in volume.

The foreign private fund flows that preceded the 1997 financial crises went to private entities in Asia and not just to sovereign borrowers as in the 1980s. Commercial bank loans in the 1990s, measured as a percentage of total foreign fund flows, were substantially less important than they were in the 1980s. Instead, fund flows to Asia ranged from foreign direct investment (FDI) to portfolio equity investment (meaning less than 10 percent ownership), corporate and sovereign bonds as well as structured notes, repurchase agreements, on top of traditional bank loans to public and private borrowers. This more diversified flow of funds generated a different distribution of risks towards global institutional investors, mainly pension funds in the advanced capital and debt markets. Stocks and bonds investments in Asia shifted market risk and credit risk to foreign institution investors who bore the risk of changes in interest rates, securities prices and exchange rates.

FDI in physical capital and real estate similarly shifted market risk and credit risk to foreign institutional investors. Even dollar denominated bonds issued by Asian governments shifted interest rate risk, as well as credit risk, to foreign institution investors. Socialized finance in the rich economies, what the Wall Street Journal fondly referred to as mass capitalism, was called on to finance old-fashioned compradore capitalism in the NIEs. The effect was to expose the NIEs to the risk of changes in US interest rates or the exchange value of the dollar, not as economic fundamentals, but as technical trends perceived by the herd instincts of fund managers in the advanced markets. Thus the neo-liberal focus on the need to resolve the national banks’ domestic non-performing loans (NPL) as a prerequisite for generating growth is, to say the least, misplaced. The NPL problem in Asia is a fiction invented by the Bank of International Settlement (BIS) to prepare national private banks as ripe targets for predatory acquisition by Western large, complex banking organizations (LCBO).