Greenspan Warns of Threat to Markets From Derivatives

Federal Reserve Chairman Alan Greenspan on Thursday expressed concern over the risks posed to financial markets by the concentration of the $142- trillion derivatives market in the hands of a few investment banks.

Greenspan repeated his usual praise for derivatives, saying their benefits materially outweighed their risks. He said the instruments had insulated the financial system from the bursting of the stock market bubble and from the economy’s troubles.

But, for the first time, he detailed the potential disruptions to financial markets if one of the major derivatives dealers had to exit the market, and he called for more meaningful disclosure of derivatives use.

“I do not wish to suggest that I am entirely sanguine with respect to the risks associated with derivatives,” Greenspan said at a conference organized by the Chicago Federal Reserve Bank.

Greenspan repeated his opposition to regulating derivatives, but said heavy concentration in the market “gives me and others some pause.”

“If a major dealer exited and other dealers were unwilling to fill the void, the liquidity of the market likely would be impaired,” Greenspan said.

Derivatives are contracts based on underlying securities or other variables, such as interest rates and currencies, that allow users to protect against risks or to make highly leveraged bets. They are used widely by financial and nonfinancial companies.

In March, billionaire investor Warren Buffett stirred worries about derivatives by branding them financial “weapons of mass destruction.” Such fears have been fanned by notable derivatives-related scandals such as the near collapse of the hedge fund Long-Term Capital Management in the late 1990s, which destabilized financial markets.