Companies Find Derivatives Are A Risky Mystery
NEW YORK — TO many Americans, the financial derivatives market in the United States is a mystery. They probably do not know what ``financial derivatives'' are.
Even the supposedly financially sophisticated find some aspects of this market enigmatic - and oftentimes risky. So the market is being scrutinized by federal and state lawmakers and regulatory commissions. Academics are eager to learn more about the often-secretive trading system. And corporate heads are investigating derivatives trading within their own businesses.
Derivatives are contracts that allow investors to bet on the direction of future price changes of underlying assets, such as stocks, bonds, and currency. Hedge funds, which are investment partnerships, are just one of the best known of the markets dealing in derivatives.
In Washington, a House subcommittee is currently looking into the multitrillion-dollar derivatives market. On May 18, the General Accounting Office (GAO) will release a new report said to call for tougher federal oversight.
The Comptroller of the Currency, who has administrative supervision over more than 3,000 federally chartered national banks, wants banks to refrain from questionable and possibly financially dangerous derivatives trades.
Although financial derivatives are one of the least-understood and most complex areas of speculation in high finance, the market is believed to encompass transactions valued at more than $14 trillion. That is more than seven times the value of all assets in US mutual funds.
Lawmakers have slowly learned in recent years that not only are speculators involved in such markets but so, too, are many of the nation's largest commercial banks and corporations. US banks may account for up to $12 trillion of the market, estimates Eugene Ludwig, the Comptroller of the Currency.
One issue now facing Washington: To what extent should banks be involved in the market, since sudden changes in financial circumstances - such as rapid movements in interest rates or exchange rates - can lead to severe losses?That same question is now being asked in corporate boardrooms. Corporate giant Proctor & Gamble Company announced a few weeks ago that it would take a pretax charge of $157 million because of losses incurred through trades on the derivatives market. The trades had apparently been undertaken by financial officers of the firm to help the company minimize losses in exchange and other currency transactions, as well as to help shore up the firm's net asset value.
Traders dealing in derivatives and hedge funds say they have gotten unfair press over their products. ``There is just a great misunderstanding,'' insists one hedge fund manager.
On the other hand, Perrin Long Jr., of First of Michigan Corporation, a longtime market observer, says the full impact of derivatives trades on traditional markets, such as the stock market, ``are little known.''
Among questions being asked by federal lawmakers: Who are the major players in the market? How are such trades executed? What impact do they have on traditional stock, bond, and currency markets? Could severe losses in derivatives begin a ``meltdown'' in the stock market or other financial markets?
Currently, securities firms are able to avoid federal oversight by conducting trades through nonbroker dealer subsidiaries or their own holding companies, which are not regulated by the Securities and Exchange Commission.
The GAO report apparently proposes minimum guidelines for trades in derivatives with oversight by the commission.
Several members of the House Banking Committee have introduced bills requiring detailed disclosure of trades by banks. Mr. Ludwig, for his part, has noted that many banks engage in derivative trades not for particular customers but, in effect, for themselves - to boost their bank's profits. Congress could enact legislation this year or next.