Derivatives are the new bugbear of the world financial system. The growing fear in many central banks and financial institutions, not least the US Federal Reserve, is that the extraordinary growth in the trading of derivative instruments has magnified in an unregulated manner the risks borne by banks and other financial institutions.

Regulators would not need to be so concerned if the main purpose of financial derivatives - such as currency options or interest rate swaps - were to correct market failures and so make markets work more efficiently. But the evidence suggests that some derivatives - particularly interest rate swaps - make destabilizing speculation easier.

Some derivatives do help correct blatant market failures such as lack of access to financial markets for small borrowers.

But for the swaps market, the fastest growing segment of the derivatives market, the efficiency case is hard to make. The advantage of swaps is that they reduce transactions costs when someone wishes to speculate on interest rates, since the cost of switching in and out of fixed- and variable-rate instruments could be prohibitive. But regulators fear that the swap market is growing faster than can be justified by speculation in transparent markets.

Swaps may, instead, serve to hide a number of risks, or to allow profitable speculation because of some risk hidden from banks and their creditors. This suspicion is reinforced by the observation that the less transparent Over-the-Counter (OTC) segment of the market is growing faster than the exchange-traded segment.

The danger is that the growth of derivatives trading may increase the systemic risk of an individual default undermining confidence in the whole bank or even in the entire market.

The fact that trading in risky derivatives activities is concentrated in the hands of a few large commercial banks increases this risk of contagion. The danger is that, particularly in the OTC market, derivatives are traded through many layers of intermediaries which distance the primary investor from the ultimate source of risk.

If the risks taken by some banks are not transparent to other banks, one can hardly expect the ultimate suppliers of capital (the holders of the bank’s equity and debt) to be aware of the risks they are taking.

Regulation is clearly needed, both indirect and direct - the question is how much. A number of groups are currently studying guidelines to improve the transparency of financial institutions involved in derivatives trading, through changes in reporting requirements. They are trying to determine what information should be made available on the concentration of bank assets and liabilities.

One proposal is that OTC trades be ‘marked to market’ as are trades on organized exchanges, and that some netting of claims and liabilities should be allowed. A more radical proposal is to force all trades to be performed via an organized exchange where the clearing house serves as a screen between trading parties and prevents default from spreading.

Is there a case for more direct intervention? After a crisis occurs, regulators will extend (or persuade the banks to extend) remedial loans in order to prevent default propagation. When the regulator is the central bank, the task of providing liquidities is made easier. Hence the role of lender of last resort played by central banks.

But ex ante, regulators face a dilemma. On the one hand, their task is to avoid contagion of defaults. For this reason, they are tempted to impose capital requirements ratios based on trading activities that insulate trading from the other activities of banks. The long-standing distinction between commercial and investment banks in the United States can be viewed in this light. It is also the major concern of the regulators who are currently establishing European guidelines.

Yet regulators must realize that banks’ growing market activities also allow them to hedge the risks that they have agreed to shoulder as a result of transactions with their customers. The example of mortgage-backed securities is a case in point. Regulators should be careful not to hinder the quiet revolution in the banking industry by artificially setting up walls between the customer business and the trading business.

 Antonio S Mello, John E Parsons and Alexander J Triantis, ‘An integrated model of multinational flexibility and financial hedging’, ESF Network Working Paper No. 42 (January 1994).