Warren Heller doesn't scare easily.
While Congress and some regulators see danger and financial meltdown in the use of off-balance-sheet instruments, Mr. Heller sees little risk. He says only 713 banks - a mere fraction of all U.S. banks - are using derivatives. Smaller still is the number - only 54 - that have derivatives positions which exceed their assets. Mr. Heller, director of research at Veribanc Inc., the Wakefield, Mass., research firm, has quickly become a leading expert on derivatives use by banks. He says that federal officials are unnecessarily jittery on the subject.
"A lot of the experts say this is an area fraught with peril," Mr. Heller said. "Well, any new area is fraught with peril. There will be some mistakes made along the way, and money will be lost."
He pointed out that while many dream up horrific scenarios about banks failing because of derivatives losses, the reality is something quite different.
"We can hypothesize all we like," he said, "but it's very important to look at the record. Derivatives have done very nicely for many institutions. There is no indication of any systemic problems."
Having said that, Mr. Heller is quick to add that the past surely is not an indicator of the future. While those in the market become more sophisticated every day, he pointed out, there is no guarantee of continued stability.
"We haven't seen all the winds that can buffet the market," he said. "Derivatives are an area where it's really hard to have a full understanding of where things are going."
Despite the potential for disaster, particularly if a major market disruption should occur, the replacement costs to banks with delinquent derivatives contracts amounts to about 0.06% of the total replacement costs of all banks.
Replacement costs, which are a significant form of exposure, come about if the counterparties renege on their end of the deal, forcing the bank to spend its own money to keep commitments.
According to Veribanc, 375 banks reported replacement-cost exposure on interest-rate and foreign-exchange-rate contracts. Of those, 41 institutions have more than 10% of their equity at risk.
While a dozen banks have replacement-cost exposures exceeding half their equity, together they represent 23% of the banking industry's assets.
"The concern has been the tremendous growth [of the derivatives market] because it has essentially been growth without oversight," Mr. Heller said. "There are a whole number of specific types of risks you can associate with the derivatives game."
He noted that while oversight and regulation of the market is helpful, it can be overdone.
Too much regulation, Mr. Heller said, would stifle the growth of the industry and drive the business overseas, both of which would not be good for the banking industry or other end users.
"There has to be a middle ground," he said. "The business won't stop, but it can be driven into another form. If you force U.S. banks from the business, overseas banks will take over."
Mr. Heller said instead of trying to eliminate the risks associated with derivatives altogether, which experts say would be impossible, regulators should be concerned with capping risk.
"Regulators should act instead of react," he said. "Put in reporting requirements and monitoring that gives you some warning."
Meanwhile, he expects the $35 trillion global market to continue to evolve.
"Exotic derivatives represent the experimental wave of the future," Mr. Heller said. "I can imagine all kinds of instruments tailored to the interest rate curve that we know nothing about now. The industry can come up with even more exotic ones than we have now."
He speculated that one of the fastest-growing segments of the industry will be in custom-tailored exotics. Figuring out how they will evolve and fit in with the rest of the securities industry fascinates him.
"The whole concept of the exotics, where you can tailor any mathematical function to any risk you want to take is exciting," he said. "That's part of what progress is all about. We could see some fascinating growth."
Mr. Heller also envisions a day when derivatives become just another run-of-the-mill credit product available to any financial institution.
"I would like to think that every bank could use derivatives," he said. "You could imagine a number of one-size-fits-all swaps contracts coming from some of the leading banks." If there is to be any future for the derivatives market, he said it would have to evolve into one where the instruments become so simple that nearly anyone can use them. "It's easy to imagine designing something that's fairly vanilla and easy to understand in English," Mr. Heller said. "Derivatives are a vibrant area that fills a need. There'll be a lot of fortunes made." Derivative Contract Replacement Costs As a percent of equity Assets Replacement in cost billions (% of equity) Banker's Trust $73.4 566%Morgan Guaranty 138.6 408Chemical Bank 132.7 346First Chicago 38.7 293Chase Manhattan 93.8 231Citibank 199.2 223Continental Bank 22.4 77 * As of first quarterSource: Veribank Inc.