A word that has been on the tip of everyone's tongue these past few months is DERIVATIVES, although the definition and understanding of their use escapes most.  What are these complex instruments derived by computer wielding rocket scientists?

Derivatives are financial contracts whose price and terms are based on underlying financial instruments.  The more standardized of these contracts trade on various derivative exchanges (CME, CBOE, NYSE) and are known as listed derivatives, while the more complex contracts with unique terms are called over the counter derivatives (OTC) and trade directly between a writer of the contract and a buyer.  Derivative contracts standardly call for periodic margin/collateral calls, or payments, by the counterparty that is out of the money on the trade.

There are two polar opposite thoughts on the use of derivative contracts; the view that the derivative gives a benefit to a company or individual and allows them to hedge and manage specific risk, versus the view that derivatives allow a company to gamble on the market, and gain off balance sheet leverage.  

Which of these views is correct?  There probably is some truth  in each view, hence the drive to better control the process and enhance regulation.  Some concerns are: 

1) Most OTC derivatives do not trade or clear on any centralized platform, and it is difficult to ascertain total market exposure for a counterparty when things start to go bad.  Secondary trading of outstanding derivative contracts without the benefit of a centralized clearer can leave payment and performance responsibilities murky.  In the past few years, there have been industry efforts to better control confirmation and recording of derivative transactions.

2) Each counterparty sets its own standards for risk collateral requirements, so a counterparty could find itself under-collateralized if the other party in the transaction is not able to make payments.  

3) Many derivative counterparties are not regulated financial institutions, but rather Hedge Funds or other financial companies, like AIG.  These entities do not have to abide by the same capital requirements that banks and securities firms do find themselves unable to make good on payments required under derivative contracts if they have not required adequate collateral, or kept capital against future exposures.  If an unregulated entity is a large enough counterparty in the OTC derivatives market (as was AIG), its inability to make payments could have a systemic affect on the overall financial system.

4) Some derivative players may have fewer automated operational processes, which could make management of transactions and risk less than optimal.  This could have an impact on systemic risk.

5) OTC derivative payments due cannot be offset against receivables from clients on listed exchanges (OTC agreements can provide for payment netting on OTC trades with the same counterparty).  The ability to net offsetting exposures with clients in the global markets, similar to the foreign exchange markets, may minimize risk.

Derivatives impacted the recent financial downturn.  How could their impact been avoided? 

Enhancements could include a centralized clearer for standardized OTC contracts.  More thought has to go into clearing and settlement issues for non-standard or tailored derivative contracts, which cannot easily be standardized for clearing and margin purposes.   If several clearing agents enter the market with different clearing and settlement standards, the market could become even more fragmented.  Centralized clearing of standardized OTC contracts may allow for offsetting of counterparty risk across the OTC and listed markets. 

Regulators can also define regulatory requirements and capital standards for ALL companies entering into OTC derivative contracts, not just the companies that are already regulated.    

It is too easy for derivatives players to cause distress in the financial markets again, so some changes to the control environment are necessary.  However, these are complicated issues that impact capital and liquidity in the markets, and care should be taken so that change agents are thoughtful in their approach and do not just react to generalized outrage.