Author Paul Erdman says that U.S. banks have lead in swaps.

Foreign banks are playing catch-up with U.S. banks when it comes to swaps and other derivatives, according to an internationally renowned economist and author.

"European banks are way down the learning curve," said Paul Erdman, an international financial analyst and author of "Zero Coupon," a fast-paced financial thriller released this month.

"Asian banks are even further behind."

Derivatives include such exotic financial contracts as forward purchases or sales of currencies and interest rates, foreign exchange and interest rate swaps, and options to purchase currencies or securities at a specific date in the future.

Relatively limited until the 1980s, they now dominate trading in securities, foreign exchange and a broad range of commodities, including gold.

As a result, regulators around the world have expressed growing concern about the increasing exposure of banks to risk of counterparty default in derivatives trading and the possibility that this could trigger a chain reaction through the market.

Like many others, Mr. Erdman warns that trading in derivatives, rather than spot purchases of currencies, commodities, or securities, is driving market prices.

"The price of physical gold is now driven by derivatives, not by traders in London or Zurich," Mr. Erdman noted.

"They guys who set the price for gold and currencies are the same ones who grew up trading futures in pork bellies or soy beans."

Buying In

Mr. Erdman noted that many foreign banks are moving to develop trading in derivatives, mainly by acquiring U.S. derivatives boutiques or hiring specialized derivatives traders.

Swiss Bank Corp., for example, bought O'Connor Partners, one of the most prominent Chicago-based derivatives firms.

Similarly, other big European and Asian banks are either buying trading firms or hiring specialists.

"The new game in town is communications and computing, and he who doesn't get a hold of it will be lost in the shuffle," Mr. Erdman said.

"You need financial innovation, imagination, computers, and geeks in the back room," he said. "It's the financial equivalent of Silicon Valley."

But when it comes to derivatives, Mr. Erdman said, foreign banks are at an inherent cultural disadvantage.

"This kind of stuff leaves the traditional banker in the dust," he said.

"What's happening in derivatives started generations ago, when Midwest farmers decided they needed to hedge the price for their crops," he added.

"U.S. traders intuitively understand these instruments, but this is still strange stuff in a country like Germany. If a German banker has to put on an operation of this sort, he doesn't have a clue."

Mr. Erdman is the author of several best sellers, including "The Crash of |79," "The Panic of |89," "The Billion Dollar Sure Thing," and "The Swiss Account."

Ingenious Scheme

He spins his latest novel around a financial maverick who, barred from bond dealing for securities offenses, moves into derivatives.

Taking advantage of the shutdown in European banks over the yearend, his protagonist bets $50 million against the German mark by selling it short in Chicago. He cashes in tenfold when the mark crumbles.

"He succeeds because foreign banks shut down over Christmas and don't open until Jan. 2," Mr. Erdman said. "We don't stop in the U.S."

A former banker turned novelist and analyst, Mr. Erdman is well placed to understand the impact of derivatives on banks and financial markets.

With everyone scrambling to get into derivatives, he believes it's only a matter of time before a major accident occurs.

"We're going to get the kind of accidents that used to happen only in foreign exchange," Mr. Erdman warned, but it's going to be in instruments that the CEO of many banks don't even understand."

Nor can regulators do much about it, he said, even though contracts on the books of banks, speculators, and money managers are estimated to have reached $7 trillion.

"Derivatives may be the driving markets, but there's also the inability of people who are supposed to be the watchdogs of these markets to even know what they're supposed to be watching."

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