Ask any banker, regulator, chief financial officer, or member of Congress what is most worrisome about international financial markets and the answer is likely to be "derivatives."

Little understood and much maligned, derivatives - the hedging and swap instruments used to manage or exchange interest, currency, and other risks - were the topic du jour when heads of more than 100 of the world's biggest banks met last month in London at the International Monetary Conference.

Derivatives, critics say, contain large, poorly understood dangers. No one has yet tested their liquidity under adverse market conditions.

Worse, many are tailor-made, and thus illiquid. Trading in derivatives, as in the foreign exchange markets, is also concentrated among a relatively small number of players. This even further exacerbates illiquidity.

True, netting can reduce risks to a small, manageable amount, but critics say that's like reducing atomic waste to a small, concentrated package of highly explosive pure plutonium.

Any breakdown in the chain of contracts involved in a derivatives transaction, or legal confusion over counterparty obligations, could trigger "systemic risk," i.e., a market meltdown as one creditor after the other fails to make good on obligations.

Rapid growth in the use of derivatives has set off much of the concern. According to recent estimates, total outstanding derivatives contracts are now approaching the $14 trillion figure.

Spectacular losses at big corporations, like Procter & Gamble Co. and Germany's Metallgesellschaft, have also increased fears that bankers are fobbing off dangerous new contracts on customers.

Partial Answer

"My concern is that derivatives should be demystified," Sir Denys Henderson, chairman of Imperial Chemicals Industries PLC, told bankers at the conference's meeting in London.

"The semantics of banking are such that people like myself find themselves unable to understand theme."

After weighty deliberations and much soul-searching, international banking regulators say they think they have a partial answer to the concerns: greater transparency, more accurate risk measurement. including counterparty, liquidity, and market risk management - and increased self-regulation.

"We have moved considerably from a historical focus of evaluating credit risk and making judgments if capital is adequate to observing the process of international management of financial institutions," observed Alan Greenspan, chairman of the Federal Reserve Board.

Cooperation, not Regulation

Given the speed at which transactions are accelerating and the proliferation of products, Mr. Greenspan said, regulators are now counting on banks to provide internal regulation to prevent accidents that could unravel the financial markets.

Mr. Greenspan's conclusions echo those recently reached by the Bank for International Settlements, the Basel, Switzerland-based clearing house for the world's central banks.

Meeting in mid-June, the BIS concluded that improved capital guidelines, improved settlement systems, and better disclosure by banks should go a long way toward helping avoid the risks inherent in derivatives.

Like Mr. Greenspan, the BIS argued in favor of regulators working together with banks to improve risk management rather than imposing a set of complicated new rules and regulations. That, regulators admit, would be virtually impossible to implement.

"It would be a mistake to assume that policy making would be easier if financial instruments could be limited or capital movements controlled," remarked BIS general manager Andrew Crockett.

Hedge Ability

Most bankers remain ardent opponents of increased regulation of derivatives.

They are even more adamantly opposed if added capital requirements or controls on derivatives-based businesses arc not extended to investment banks or other institutions dealing in the same products.

Controlling or reducing banks' ability to supply derivatives, bankers argue, would also do a disservice to financial markets by reducing the ability of borrowers to hedge against risks, thereby shrinking their funding possibilities.

"The derivatives market is of huge value to its users because it allows the diversification of risk, the management of financial exposure, and is a genuine aid to increasing the efficiency of the market place," says Rainer Gut, chairman of the board of Switzerland's CS Holding.

Mr. Gut argues that much of the concern about derivatives stems from the very size of the market and the fact that the instruments being used are "opaque, arcane, and badly understood by all except users and the financial intermediaries providing the products."

'Don't Create New Risks'

Like other bankers, however, he argues that this should not lead to "ill-conceived, poorly reasoned,-knee-jerk reactions from politicians and possibly, regulators" that would cut back on the use of products whose purpose is to reduce risks.

Or, as Dennis Weatherstone, chairman of J.P. Morgan & Co., put it bluntly earlier this year: "Derivatives don't create new risks. They allow us to unbundle risks that used to come in a package."

Bankers like Swiss Bank Corp. president Georges Blum squarely lay blame for some of the recent disasters with derivatives on errors in strategy.

"Derivatives as such have not produced the losses, but the way in which they were used" did, he observed at an international management symposium in Switzerland last month.

"Strategies have been wrong because the techniques were inadequately applied ... or because a speculative gamble which was explicitly accepted as a way of achieving an extraordinary profit turned out to be a losing bet."

Areas of Concern

Mr. Blum lists six areas of concern, three of them applying to financial institutions and three to regulatory bodies. Financial institutions, he says:

* Pay too little attention to risk beyond normal day to day market fluctuations.

* They rely too heavily on sophisticated mathematical models.

* And, they fail to consider setting aside the capital they may need to cover risks occurring in unusual circumstances.

"Excellent mathematicians and a sophisticated technical infrastructure do not guarantee good risk management," Mr. Blum observed. "Risk management in the first instance is a leadership task - to define the aims, the ways and means, and the philosophy behind risk management and control."

On the regulatory side, Mr. Blum levels three criticisms.

* Failure of regulators to clarify their objectives.

* Failure to distinguish between experienced and inexperienced market participants.

* And, failure to Clarify settlement risks.

More specifically, neither bankers nor regulators yet have an answer to what happens when you have different counterparties in different countries with different legal and accounting systems and one defaults on its obligations.

'Vague Formulations'

"We are not satisfied with the extremely vague formulations of many regulators, especially if you look at recent initiatives in the U.S." Mr. Blum remarked. "There also seems to be a need for the supervisors to be more in line with each other on what their aims and instruments should be. Up till now, they have not been speaking with one voice."

Despite many of the reservations, no one disputes the assumption that derivatives are here to stay.

"A likely explanation for the enormous increase in volume is the vast savings in transaction costs from their use," observes Robert C. Merton, professor of business administration at the Harvard Business School in Cambridge, Mass.

"Looking to the future, with such costs savings, we are not going back. Derivatives are a permanent part of the mainstream global financial system." End users, like France's Agache Group, add that operating today is becoming impossible without derivatives. "The post-Bretton Woods era has seen an outburst of instability on various markets: currencies, interest rates, stock. crude oil, and other raw materials," observes Roberte Leon, group manager at Agache.

"Most companies will thus want to limit their risks and reduce the uncertainty of their future cash flows and earnings so that in a stock market turmoil, they can minimize the heart attack rate of their shareholders."

Mr. Leon cites four main reasons why corporations like his use derivatives:

* To make day-to-day risk. management easier.

* To improve the accuracy of hedging.

* To reduce financing costs.

* To provide strategic options by allowing more flexible equity structuring.

Like bankers and regulators, Mr. Leon admits the risks are there. But he remains convinced they can be mitigated by the intelligent use of derivatives.

"Derivatives don't wreak havoc," people do. he said.

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