VideoIn 1958 American onion farmers, blaming speculators for the volatility of their crops' prices, lobbied a congressman from Michigan named Gerald Ford to ban trading in onion futures. Supported by the president-to-be, they got their way. Onion futures have been prohibited ever since.
Futures are agreements to trade something at a set price at a given date. They are perhaps the simplest example of a derivative, a contract whose value is "derived" from the price of a commodity or another asset. Derivatives continue to be vilified, usually when someone loses a lot of money. Orange County and Procter & Gamble lost fortunes on them in the 1990s. They were at the core of Enron's failure. And in September 2008 they brought American International Group (AIG), a mighty insurer, to its knees. Its fetish for credit default swaps (CDSs), a type of derivative that insures lenders against borrowers' going bust, led it to guarantee at least $400 billion-worth of other companies' loans-including those of Lehman Brothers. The American government forked out $180 billion to save AIG from collapse.
Every catastrophe brings calls for restrictions on derivatives. This year Joseph Stiglitz, a Nobel economics laureate, has said that their use by the world's largest banks should be outlawed. But derivatives have defenders too. Used carefully, they are an excellent-some would say indispensable-tool of risk management. Myron Scholes, another Nobel prize-winner, says a ban would be a "Luddite response that takes financial markets back decades."
Because of the mayhem of the past year or so, lawmakers in America and Europe are on the point of giving derivatives markets their biggest shake-up since the 1970s. For the world's biggest banks, billions of dollars are at stake. For taxpayers, the stakes are just as high.
Derivatives come in many shapes. Besides futures, there are options (the right, but not the obligation, to buy or sell at a given price), forwards (cousins of futures, not traded on exchanges) and swaps (exchanging one lot of obligations for another, such as variable for fixed interest payments). They can be based on pretty much anything, as long as two parties are willing to trade risks and can agree on a price: commodities, currencies, shares, or bonds. Derivatives create leverage too. Contracts are sealed with initial payments that are a small fraction of the potential gain or loss.
In the main, businesses use derivatives to shift risks to other firms, chiefly banks, that are willing to bear them. An airline worried about fuel prices can limit or fix its bills. A bank concerned about its credit exposure to the airline can pass some of its default risk to other banks without selling the underlying loans. About 95% of the world's 500 biggest companies use derivatives. A lack of them can be costly. "The absence of derivatives in iron-ore markets makes negotiations between Australian suppliers and Chinese buyers very confrontational," says Philip Killicoat of Credit Suisse. Earlier this year Rio Tinto's chief negotiator, Stern Hu, was arrested in China during hard bargaining over prices. And the futures ban has not stopped the price of onions from going up and down.
Derivatives have a long history, stretching back thousands of years. In the 17th century the Japanese traded simple rice futures in Osaka and the Dutch bought and sold derivatives in Amsterdam. But trading in financial derivatives really took off only in the 1970s. The fluctuations in currencies and interest rates after the collapse of the Bretton Woods system gave a push to demand. The option-pricing formula developed by Fischer Black and Mr. Scholes, plus advances in computing power, made valuing derivatives much easier. Regulators encouraged them, too. Thrift Bulletin 13, issued by the Federal Home Loan Bank System in 1989, obliged American thrifts to hedge their interest-rate risk.
Derivatives are bought and sold in two ways. Contracts with standardized terms are traded on exchanges. Tailored varieties are bought "over the counter" (OTC) from big "dealer" banks. These banks support the OTC market by hedging their clients' risks with each other or on an exchange.
The OTC market dwarfs exchange trading. Estimating its size, however, demands caution. In figures published this week the Bank for International Settlements, the central bankers' central bank, puts its "notional" value at $604.6 trillion. But "those numbers don't appear on anyone's balance sheet," says Barry Epstein, an accountant who specializes in derivatives. For example, the notional value of the CDS market is $36 trillion, says the BIS. But that counts all guaranteed debt-the equivalent, in home insurance, of the value of houses covered rather than premiums paid.
For interest-rate contracts, notional values are even more misleading because they are based on principal amounts; actual obligations depend on interest payments. "Gross market values," which show how much money would change hands if derivative contracts were sold on the reporting date at prevailing prices, are a better guide. But even they are an overstatement. Once banks' claims on each other are stripped out, the residual ("gross credit exposure") is $3.7 trillion, well under 1% of the notional total.
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