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What's so dangerous about derivatives?" Institutional Investor asked back in September 1992. Quite a bit, as European Bureau Chief Kevin Muehring and Senior Writer Saul Hansell showed over the course of this cover story. 

It's a classic Institutional Investor story, breaking down a complex and opaque topic and delivering it to the reader in a digestible format. But few II stories — few stories by any media outlets — have quite the prescience of this one. (See the section on nightmare scenarios, for example.)

Hansell and Muehring had been covering the topic for several years and wanted to highlight the dangers and the need for sensible regulation. Indeed, Muehring was so keen to pick the brains of then New York Federal Reserve Bank president E. Gerald Corrigan, the loudest voice on derivatives at the time, that he refused to be turned off by repeatedly declined interview requests and chased Corrigan around the world, eventually catching up with him in Basel and again in London.     

This is the most recent in our ongoing series, From the Archive, which highlights the best of Institutional Investor's  financial journalism over the course of the last four decades. See also International Editor Tom Buerkle's 2002 story,  What's Wrong with the ECB

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September 1992, Cover 
"I wasn't born yesterday," New York Federal Reserve Bank president E. Gerald Corrigan is fond of saying. His formative experience as a central banker was the Herstatt Bank crisis of 1974, when the collapse of an obscure German bank sent shock waves through the Euromarket. Since then Corrigan has dealt with the debris of the LDC crisis, the collapse of Continental Illinois Corp. and the depredations of Drexel Burnham Lambert. "I have seen them all," says the burly regulator in his gravelly voice.

So it was with a jaundiced eye that Corrigan began to probe the banks under his supervision about their headlong rush into the financial phenomenon of the decade: over-the-counter derivatives. Do you know the risks you are taking and how to control them? he asked. And as chairman of the Bank for International Settlements' banking supervisory committee, Corrigan was also seeking answers to the question looming ever larger in the minds of his fellow regulators in Basel: Could these new markets somehow destabilize the financial system?

The market for the highly technical, tailor-made instruments created through stand-alone or embedded interest rate and currency swaps, options and the complex combinations thereof, and known loosely as derivatives, has mushroomed eightfold in just five years. Its notional value is a whopping $4 trillion, according to the BIS, which works out to an estimated $250 billion in actual credit risk. For Corrigan, numbers like this in what has been a spottily regulated market -- one, moreover, that crisscrosses equity, fixed-income, foreign exchange and commodities markets -- are hard to ignore. Especially difficult to overlook is the fact that a mere dozen U.S. banks hold accumulated positions of $150 billion.

The responses he heard back from the bankers were not comforting. They admitted that they didn't really understand derivatives or how much money they could lose if something went haywire. To be helpful, they offered to introduce Corrigan to their head derivatives traders. Big blunder. The million-dollar-a-year swaps experts proceeded to brush off Corrigan's concerns as if he were some Luddite in a pin-striped suit: "Jerry, Jerry baby, you don't understand the business. We know what we're doing. Now don't go and spoil the party." Thus does one top banker, who was hastily deployed to placate Corrigan, characterize the swappers' condescending attitude.

It was no surprise when Corrigan decided to flex some regulatory muscle where derivatives were concerned. In a much-remarked speech before the New York State Bankers Association on January 30, Corrigan told his audience bluntly that they had better "take a very, very hard look at off-balance-sheet activities." In case anyone missed the point, he added, "I hope this sounds like a warning, because it is."

Nightmares

Corrigan's speech hit the bankers like a billy club, putting a whole new spin on discussions of derivatives. Soon, in press reports, in political speeches, even in cocktail party chatter, derivatives were being talked about in worried tones as the possible cause of a financial melt-down. Derivatives are "a time bomb that could explode just like the LDC crisis did, threatening the world financial system," warned Royal Bank of Canada chairman Allan Taylor at the International Monetary Conference in May. And Lazard Freres & Co. senior partner Felix Rohatyn was quoted in this magazine's 25th Anniversary issue in July as worrying that "26-year-olds with computers are creating financial hydrogen bombs."

What awful potential disasters have these people so frightened?

The scenarios fall into two categories. The Worst Derivatives Nightmare I is that derivatives trading itself could cause a major bank to fail. It would take some doing, but a bank conceivably could wipe out its capital this way. The regulators' Worst Derivatives Nightmare II is in some ways a lot more hair-curling, because it is less predictable and therefore would be harder to cope with. That is the prospect that derivatives, simply because they now invisibly permeate the entire financial system, could turn an ordinarily containable situation -- one that isn't even caused by them -- into a full-blown financial crisis. Says Federal Reserve Board vice chairman David Mullins Jr., "As a central bank, we think a lot about small-probability, high-stress events."

Before everyone heads for the fallout shelter, it's worth considering whether the biggest problem raised by derivatives is not the products themselves but the challenge they pose for the patchwork of regulations intended to safeguard the world's finances. Sure, derivatives give institutions new ways to lose money or even fail, and they create a network of interbank transactions that could change the character of the financial system. And since most governments explicitly or implicitly commit themselves to bailing out commercial banks that get in trouble, supervisors have every reason to insist in the strongest way that these new risks be understood and handled prudently.

Yet a close examination of the derivatives business shows that, while it is hardly risk-free, it is far less precarious than traditional financial activities. Lending money to shopping mall developers or trading mortgage-backed bonds -- to take just two examples -- are actually more dangerous than dealing in derivatives. What makes derivatives different is that, neither loans nor securities, they are largely unaccounted for in the current legal structure of finance. This makes the regulators feel, with some justification, helpless.

Over-the-counter derivatives will eventually force the world to rethink how it supervises finance, accounting for the blurred roles of banks, securities firms and other players. Risk will ultimately have to be managed not with government supervision but with capital and strong firewalls between institutions and their affiliates. And government safety nets for banks will have to shrink.

So far, so good

The dealers, of course, are quick to point out that derivatives, to date, have caused far fewer losses and other market disruptions than run-of-the-mill financial products. And there are no warning tremors of systemic risk similar to the volatile triple-witching-hour days that prefigured the 1987 crash of the U.S. stock market. Not even all the regulators are frightened. "There is too much alarmist rhetoric involving these products," argues U.S. Securities and Exchange Commission chairman Richard Breeden. "We've seen 2,500 banks fail because of credit risk. We have a long way to go before the swaps market is as threatening."

Derivatives dealers have been known to suggest -- sometimes with a smugness that's said to so infuriate Corrigan -- that generational factors are at work in the dread of derivatives. Older regulators and bankers, they say, fear things that they haven't taken the time to understand. Though derivatives are no more incomprehensible than VCR programming instructions, they are based on theories that have been included in business school curricula for only a decade. And they do require a certain amount of college-level math to value.

Political motives may also underlie the official scare stories, dealers imply. Competitors of derivatives dealers -- such as futures exchanges -- have reason to cast doubt on this upstart market. Cynics note that Corrigan himself might have felt he needed a holy crusade to counter criticism for having been slow on the uptake concerning the scandals at Bank of Credit & Commerce International and Salomon Brothers. "Jerry wants to be the chairman of the Fed," says one senior American regulator. "He wants to be out front on this and look tough."

Although there may be some truth to the dealers' self-serving observations, they unfairly undercut the real challenge derivatives represent to the existing structure of financial regulation. For a start, it's hard even to figure out where derivatives fit into the usual scheme of rulemaking by types of institution; they're used by every conceivable kind of organization, from banks and brokers to insurers and pension funds to corporations and governments. Within most countries no single agency oversees derivatives.

Of course, the business is dominated by multinational institutions that operate in dozens of countries. What's more, because over-the-counter derivatives aren't loans or deposits or stocks or bonds or exchange-listed futures and options, they tend to fall outside the usual regulations governing financial instruments.
Complicating matters still further, many derivatives are types of options, so their value at any given moment is a function of a complex calculation of the probability that they will eventually be exercised. Such high math is not exactly compatible with the prosaic methods of conventional accounting, making it troublesome for regulators to set meaningful capital rules. Derivatives, notes Richard Farrant, the Bank of England's deputy director of banking supervision, are "at the frontiers of the accounting system."

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