More Than Just New Financial Bingo: A Risk-based Approach to Understanding Derivatives

The large losses suffered by investors in financial derivatives during recent years have prompted a wave of litigation, as well as proposals from Congress and regulatory agencies for increased monitoring of derivatives markets. Many, including some members of Congress and even "industry experts," are uneasy with the growing use of derivatives. Yet many market participants and others knowledgeable about this growing industry insist that derivatives serve an important, and perhaps vital, purpose by allowing investors to better manage the financial risks associated with their business transactions.I define the term derivative and briefly discuss the history, uses and types of derivatives, as well as the various derivatives market participants. I then provide an explanation for recent derivatives losses through an analysis of the risks inherent in derivative products and markets (market, credit, legal, operational, liquidity and systemic risk) and discuss how these risks are currently being managed. I then conclude that, because the derivatives market is a zero-sum game, regulation is only appropriate with respect to those systemic risks that threaten the financial system as a whole. Regulators and market participants have already taken substantial steps toward controlling systemic risk. Nonetheless, further international cooperation and regulatory guidelines in some areas, particularly disclosure and accounting standards, could lend certainty and stability to the derivatives market.