Can the market for derivatives - or "financial weapons of mass destruction," as Warren Buffett memorably described them - be tamed?
As government and industry struggle to contain the panic in global markets, few questions are more urgent.
Derivatives are supposed to stabilize financial markets. Just as firms trade commodities futures to protect against supply disruptions, financial institutions use derivatives to bet on changes in interest rates or foreign exchange rates - or on the creditworthiness of their business counterparties. Unlike commodities futures, however, most of the world's $600 trillion derivatives market does not trade on exchanges, where participants must show that they have enough money to cover their losses. Instead, contracts are negotiated "over the counter" between individual parties; if someone defaults, no central clearinghouse sorts out the mess. If one or more of the big, interconnected financial institutions that operate in derivatives markets were to go bust, this lack of consistency and transparency could trigger a dangerous chain reaction. Derivatives-related systemic risk helps explain why the Federal Reserve bailed out Bear Stearns and AIG - and why the collapse of Lehman Brothers spawned so much fear.
So far, though, the derivatives doomsday scenario has not materialized. Multitrillion-dollar estimates of the market somewhat overstate the danger. Traders bet both sides of various risks, so their trades offset one another. For example, there were some $400 billion worth of derivatives linked to the solvency of the late, lamented Lehman Brothers. But when they all settled out Oct. 21, less than $8 billion actually changed hands.
Still, it would be wrong to underestimate the risks. Derivatives known as credit default swaps, a roughly $50 trillion market, are essentially insurance contracts in which one party pays a periodic fee to a second in return for a promise to pay upon the default of a third, known as the "reference entity." These have been negotiated bilaterally among a bewildering array of parties, with little transparency or standardization. The collapse of one or more "reference entities" - a couple of major banks, say - could bring about Mr. Buffett's financial Armageddon.
Transparency is the best answer to the threat. One recent step in the right direction: The Depository Trust and Clearing Corp., which operates a central registry for credit default swaps, has announced that it will begin publishing weekly data on that market. Beyond that, as much derivatives trading as possible must be moved onto accountable, regulated exchanges, similar to the commodities exchanges. The industry has been gradually moving that way: On Oct. 31, 17 major banks announced that they may accomplish the first step toward an exchange - the establishment of a clearinghouse for trades - by the end of this month.
The industry must agree quickly on margin requirements and other risk-management measures so that this vital, and long-awaited, reform can proceed. If industry does its part, federal regulators should provide the necessary approvals with a minimum of interagency squabbling. The derivatives time bomb may still be ticking, but consistent pressure from regulators and enlightened self-interest from industry could yet disarm it.