The Financial Market’s Shadowy New Risk : Derivative dealing attracts Washington’s attention
The world’s financial markets are complicated enough these days, what with the lightning speed of computer trading. Now along comes a relatively new wrinkle called derivatives. These are special financial tools that only the biggest investors can use to hedge their bets and protect their portfolios.
In some respects the world of derivative dealing is a scary one. Even Washington is starting to pay close attention to the growing use of these arcane, highly sophisticated financial instruments. Although derivatives are little understood or used outside of Wall Street, some companies, banks, brokerages and even mutual funds seem to love them; the face value of derivatives in play today is an awesome $15 trillion.
Derivatives are financial contracts that derive their value from another asset, such as stocks, bonds or commodities. Their purpose is to diminish risk. They do this by offering all sorts of contracts--swaps, options, forwards, caps or collars, to name a few--that can be used to hedge against fluctuations in interest rates, foreign exchange rates and stock and commodity prices. Small investors can’t use derivatives--only huge institutions like large banks, high-flying brokerage houses, mutual funds.
The possibility that unregulated derivatives could, in extreme cases, pose a systemic risk to world financial markets is prompting Congress to consider safeguards, especially oversight and disclosure. In introducing a bill in January to create a Federal Derivatives Commission, Rep. Jim Leach (R-Iowa) described them as “the new wild card in international finance.” Last Wednesday Rep. Edward J. Markey (D-Mass.) called on the Securities and Exchange Commission to study the link, if any, between derivatives and the current volatility in the stock and bond markets. The House Banking Committee will hold a hearing on derivatives Wednesday. Used intelligently and with care, derivatives provide immense benefits by creating a vast pool of financial resources worldwide. Through computers, they allow money to grow in new ways. In some practical applications, derivatives--which amount to speculative side bets-- enable businesses to improve their ability to secure financing and various other benefits.
However, they also pose huge risks that disclosures and better accountability might help to at least mitigate. Few if any of the companies, banks, brokerages, insurance companies, mutual and pension funds and other institutions that deal in derivatives break out these transactions on income statements or balance sheets. It is this woeful lack of accounting that is worrisome.
Derivative dealing must be moved into the light. After all, consider the downside: the huge risks involved when interest rates shift sharply or international events intervene to trigger derivative defaults that then might panic financial markets.
So far, thankfully, derivatives’ losses have been contained and isolated. The giant German company Metallgesellschaft lost $1.3 billion last year on a bet on oil futures. Financier George Soros lost $600 million in February in mistakenly projecting a rise in the U.S. dollar against the yen.
The thought that a series of such derivative losses might have a devastating domino effect is a chilling one. Common sense calls for disclosure, accountability and maybe some sensible if limited regulation.
