Be afraid! A year after AIG, derivatives remain big risk

The global financial crisis has introduced ordinary people to the extraordinary and arcane world of "derivative product" — a gigantic system of commercial bets in financial markets where the total outstanding amount of derivatives adds up to a mere $600 trillion (some 10 times the value of global production).

The City is one of the leading centres of this trading activity.

A year ago, AIG was brought to the brink of bankruptcy because of its exposure to one type of derivative — credit default swaps (a form of credit insurance). Asset-backed securities and collateralised debt obligations — also cheerily known as Chernobyl death obligations — helped to bring the financial system to the edge of collapse.

Volatile equity and currency markets caused problems with exotic option "accumulators" and now numerous investors and corporations are hunkered down with their lawyers hoping to litigate their way out of significant losses on "hedges" pleading such familiar defences as "I did not understand the risks" or "I was misled about the risks by the bank".

If you thought this would lead regulators such as the Financial Services Authority, the Bank of England and America's Federal Reserve to tame the wild beast of derivatives, then you would be wrong. History tells us that there will be cosmetic changes to the functioning of the market but business as usual will resume in the not too distant future.

Previous episodes of derivative problems — portfolio insurance in 1987 and long-term capital management in 1998 — never led to changes in fundamental issues such as using derivatives for speculation, mis-selling instruments to less-sophisticated market participants and excessive complexity.

The industry and its key lobby group, the International Swaps & Derivatives Association, are well-practised in the art of playing the regulatory game.

Derivatives, it will be argued, are so complicated that only derivative traders themselves can properly "regulate" them. The new centralised counterparty to reduce the risk of a major dealer failing is only for "standardised" derivatives and already there are impassioned debates about what is meant by "standard derivatives".

On 17 September, the chief executive of the derivatives association, Robert Pickel, told the House Agriculture Committee in America: "Not all standardised contracts can be cleared," because even if they have standardised economic terms, many derivatives contracts will be "difficult if not impossible to clear" since the counterparty depends on liquidity, trading volume and daily pricing. This would, Pickel said, make "it difficult for a clearing house to calculate collateral requirements consistent with prudent risk management."

Dan Budofsky, a partner at legal firm Davis Polk & Wardwell, who testified on behalf of the Securities Industry and Financial Markets Association, agreed that "it may be more appropriate for products that trade less frequently to trade over-the-counter". The industry will argue for self-regulation, which is about as close to regulation as self-importance is to importance.

The reasons for policy inaction are complex. Derivatives do perform important risk-transfer functions within modern capital markets — their Dr Jekyll side — and Pickel eloquently made the point that standardisation and the centralised counterparty "would undercut [derivatives'] very purpose: the ability to customise risk-management solutions to meet the needs of end-users".

But derivatives also have a Mr Hyde side: they are used to speculate, keep dealings off-balance sheet and out of sight, increase leverage, arbitrage regulatory and tax rules and manufacture exotic risk cocktails.