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Over the counter, out of sight
Nov 12th 2009 From The Economist print edition

Derivatives are extraordinarily useful—as well as complex, dangerous if misused and implicitly subsidised. No wonder regulators are taking a close look
Illustration by Otto Dettmer

IN 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. Butderivatives 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.”[18/11/2009 10:28:54 p.m.]

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, nottraded 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 thepotential 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 usederivatives. 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 fromgoing 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...
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