A derivatives 'bubble' only exists if everyone bets one way and prices end up moving the other. That data is completely meaningless without understanding the nature of the products and how they are hedged - which by definition nobody has access to. Suggesting that all derivative exposure is toxic is nonsense.

Derivatives are not inherently a bad thing - they are in fact an entirely sensible way for financial institutions and corporates to insure themselves (at least partially) from market volatility and fluctuations to which they are exposed.

Derivatives become a bad thing when they are used to generate profits by those that should only be using them to hedge their exposure. Attempting to make derivatives a profit centre, combined with often dreadfully poor risk management practices, is where banks have been going consistently wrong since Barings.

Agreed with Brisbane Rhino, the basic concept of a derivative is just a form of insurance but the way they are used is totally inappropriate for insurance.

If you buy insurance for your house burning down then only you have insurance for it, if your house burns down then your insurer pays out for the damage (this is effectively the reason AIG went bust because of having to pay out many multiples of times when defaults they were insuring against happened)

But if this was done by derivatives, you could buy a derivative that paid out in the event of your house burning down....but also several other people could buy a derivative paying out in the event of your house burning down. So if your house burns down then you get the pay out but so do many other people. For you, you've lost your house and been compensated, but for the other people that also burnt derivatives based on your house burning down, they have just received a nice pay out and not suffered a burnt down house. The insurer has had to pay out multiple times so its bad for the insurer too.

Of course the other problem here is there are now many unconnected people that have a vested interest in your house burning down as they profit from it. In the concept of business and defaults, or mortgages and defaults, this can be a real problem if there are big financial players in the market that can influence that bad event happening.

Eg if I am a predatory lender I could make a mortgage loan to a borrower with a very poor credit history, that was a high risk of defaulting....if I could then disguise the risk of that loan and get ratings agencies to pass it off as AAA rated (which is what was going on), I might be able to sell that loan to someone else so now someone else has taken the risk. If I then buy a derivative that pays out in the event of that loan defaulting then I get a payout on default.

Alternatively if I was a major shareholder in a business and a key provider of finance to that business, I could buy a derivative that pays out in the event of the business going bust, and then suddenly sell the shares to prompt a tumbling in the share price, at the same time as cutting finance to that business, help make sure it goes under, then I get the payout from the derivative.

The widespread use of derivatives meant that there was a serious issue in terms of incentives at the top end of the financial services industry....the financial services industry is meant to be there to facilitate business and help keep it flowing, but once these derivatives were floating around there were a lot of major banks that had vested interests in individual businesses going bust, because that would trigger the payouts on those derivatives.

That is fraud and there are laws to deal with it.



That is market abuse and there are laws to deal with it.

The lack of understanding of derivatives by people spend a lot of time talking about it is frightening (this is where someone marks a smart comment about the Sales desk of your average investment bank). I bet the OP can't even name the four types of derivative without looking it up on Wikipedia.

The problem is the lawmakers (and internal risk managers within banks) are often well behind the 'smartest guys in the [trading room'. Financial institutions should simply bar any and all trades in instruments which their risk analysts cannot clearly define and therefore value. That is, if you cannot explain what will cause the value of the derivative to rise or fall, because you don't actually know the underlying assets it is based on, why on earth are banks allowing traders to buy/sell them?

It is truly astounding that after so many well-publicised events (some involving fraud but many down to senior management simply not comprehending what the heck their traders are doing), so many banks simply had no idea of the scale of their exposure to US sub-prime debt, even well after the initial collapse of the underlying market (US sub-prime property values).

I'm not against the use of derivatives at all - I have been actively involved in their use for a number of years to manage commodity risk. The problem as I say is when institutions that ought to be conservative - i.e. lending banks and building societies - start to dabble in products they shouldn't, with the aim of making profit rather than manage risk. In the event banks far too often allow their traders to put them into far riskier positions than if they allowed no hedging at all.

If you would like a simple view of the bankers, just go to youtube and type in "Wall Street W[ia[/inkers"

It's also worth viewing the orginal: "Irish W[ia[/inking Bankers"

Scripted or not, it still pretty much sums everything up in layman's terms