Are Derivatives Dangerous?

Without adequate collateral, one big default could set off a chain reaction imperiling the whole financial system

The debate over derivatives is heating up again. Federal Reserve Chairman Alan Greenspan said last November that they have contributed "to the development of a far more flexible, efficient, and resilient financial system than existed just a quarter-century ago." But Warren E. Buffett, the billionaire investor from Omaha, wrote to shareholders of Berkshire Hathaway Inc. in March that "derivatives are financial weapons of mass destruction." Here's what you need to know to understand the debate:

What are derivatives, anyway?

Think of them as side bets: financial contracts in which two parties take opposite positions on how a price, a rate, an index, or a natural phenomenon such as the temperature in Chicago is going to change. The contract's value is "derived" from the underlying asset.

What are they good for?

They transfer risk from people who don't want to bear it to speculators who are willing to do so in return for the chance to make a profit. By shedding unwanted risks, companies can afford to invest more in their core businesses. That promotes economic growth. For example, a company that owes a variable rate of interest on a $1 million loan could limit its risk by entering into an interest-rate swap that transforms its obligation into a fixed rate.

How big is the market?

The International Swaps & Derivatives Assn. recently estimated the worldwide market at $105 trillion. The Office of the Comptroller of the Currency (OCC) says U.S. commercial banks held $56 trillion of derivatives at the end of last year.

Trillions? Isn't that pretty risky?

Such large sums never change hands. They are only "notional amounts" that are benchmarks for deciding how much parties owe each other. For instance, a $1 million interest-rate swap might involve no net payments at all if the floating interest rate remains the same as the fixed rate. A better measure of what's at stake economically is the various parties' exposure to default by other parties. At the end of 2002, it was a little under $500 billion for U.S. banks, the OCC says. The market value of contracts that were at least a month overdue was just $36 million -- less than one-millionth of the $56 trillion notional amount.

So there's nothing to worry about?

Actually, there is. For one thing, exposure to derivatives is highly concentrated. The OCC says just seven U.S. banks own nearly 96% of the derivatives in the banking system. And because most derivatives are traded directly between the parties and not on exchanges, they are almost entirely unregulated. In deals executed on exchanges, unlike those done privately, the parties must post collateral (known as margin) up front. They add to it if their position is losing money.

Why does collateral matter?

Collateral -- typically cash or government securities -- ensures that the losing party in a derivatives contract will pay up. Without collateral, there could be a daisy chain of defaults that imperils the entire banking system. Since private deals aren't regulated, the amount of collateral the parties require from each other is generally less than on exchanges. Although the private market is riskier, it's also cheaper to trade on -- one reason so much business is transacted outside exchanges.

Aren't some critics particularly worried about credit derivatives?

Yes. They were designed to recompense a creditor if a debtor defaults. They allow investors to speculate on a company's creditworthiness. But some, such as "synthetic collateralized debt obligations" -- bond-like derivatives whose payouts fall when defaults rise -- are extremely complex. And buyers such as pension funds may not understand fully the risks they're taking on.

Is anything being done?

Not much. Senator Dianne Feinstein (D-Calif.) has a bill with Republican co-sponsors to increase regulation of energy and metals derivatives, but its fate is uncertain. The Commodity Futures Trading Commission and the Federal Reserve have done little. Unless there's a replay of the Long-Term Capital Management meltdown of 1998, no major change in the rules is likely.

By Peter Coy in New York

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