Market Reform's Effect on Derivatives: No more "weapons of financial mass destruction"?

Warren Buffett called them “weapons of financial mass destruction” and they have been heavily blamed for the meltdown in the financial system and the freezing of credit markets over the past 2 years. Financial derivatives represent trillions of dollars in securities that trade hands around the world every single day. Yet they are one of the least understood financial instruments.

Derivatives can be traced back more than 200 years, when rice farmers in Japan would sell their crops at a set price today, promising to deliver those crops when they were harvested at a later date. The price was based on what the buyer and seller “guessed” that the price would be a few months down the road. Derivatives started out then as an innocent, simple financial tool for those involved in the buying and selling of commodities. A derivative is simply a financial contract with a value derived from the underlying value of some good or commodity.

Fast forward to the late 1990s and derivatives had transformed into much more complicated vehicles. The commodities involved in many derivative contracts were no longer just rice and beans, but rather interest rates, mortgages, and other financial assets with no intrinsic value. Credit derivatives, for example, are a tool used to shift risk from one financial institution to another. As soon as the housing market started to decline and foreclosures started to increase, the mortgages in these contracts became what we now call “toxic debt.”

The biggest problem with financial derivatives was a serious lack of regulation. Ten years ago, legislation allowed for derivatives to be traded over-the-counter with no regulation. The thinking was that the commodities markets were already regulated, so there was no need for an extra layer of regulation when derivatives were made up of commodities. Soon, banks were packaging sub-prime loans into contracts along with traditional, safer mortgage-backed securities, but it was impossible to determine where the bad loans were once they were packaged and traded. Banks with billions of dollars worth of credit default swaps and other financial derivatives were stuck holding securities that were impossible to determine a value for.

The presence of these types of securities in hedge funds managed by Lehman Brothers and Bear Stearns led to the collapse of those two financial giants, both companies with respected track records of more than 100 years. Other financial institutions and insurance companies, including AIG, also held massive amounts of these toxic assets.

The future of derivatives is nothing but uncertain, as lawmakers and regulators are still trying to rebuild the foundation under the financial system and instill confidence back into the financial world. The answer will probably lie in greater regulation, but there will also be greater scrutiny among parties entering into future contracts and trading in derivatives. The Obama administration has made it clear that they want more oversight in the derivatives market, which will likely lead to requirements that derivatives be traded on regulated exchanges rather than over the counter.