Derivatives markets must become more mature. Tim Geithner, US Treasury secretary, last week proposed to regulate the products investor Warren Buffett once likened to “weapons of mass destruction”. The US plan is welcome – but too vague on important questions.
Derivatives can be tremendously useful. Creating financial instruments that depend on uncertain future events – such as how interest rates change or whether bond issuers default – allows risk to be traded and distributed. But lack of oversight has undermined this benefit.
Most derivatives are lightly regulated “over-the-counter” deals; their face value is more than tenfold that of derivatives traded on exchanges. Criss-crossing OTCs have grown into a jungle where companies, such as AIG, were able to use derivatives to avoid capital requirements. Some products meant to limit risk bury it in complexity, or just transform it into counterparty risk or systemic risk instead.