Billionaire Warren Buffett has long warned that derivatives -- complex financial instruments whose value is based on underlying assets from stocks and bonds to gold -- are "time bombs" that require cautious handling, but that hasn't kept companies from using them.
"These instruments will almost certainly multiply in variety and number until some event makes their toxicity clear," the Berkshire Hathaway (BRK.A) CEO, who recently exited his remaining credit-derivative contracts, said in 2003. "Derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal."
The financial crisis five years later illustrated the validity of Buffett's assessment, with arcane instruments like mortgage-backed securities and credit-default swaps becoming almost household terms.
Today, though, the financial system still holds massive amounts of derivatives, with the global market valued at nearly $15 trillion. Citigroup (C) has become the largest U.S. holder of the instruments, a position fueled by the purchases of large portfolios from European lenders Credit Suisse (CS) and Deutsche Bank (DB) .
While the market encompasses securities from futures contracts to stock options, it's one particular type -- credit-default swaps -- that have drawn the most pointed criticism in recent years. The swaps, which function as insurance to protect purchasers against losses in other securities, gained notoriety when insurance giant AIG (AIG) -- a prominent issuer -- required a $182 billion bailout to meet its payout obligations during the crisis.
"Credit derivatives ought to be more of a concern for regulators than other kinds of derivatives," University of Colorado-Boulder law professor Erik Gerding said in a phone interview. "Credit derivatives allow parties to offload risk and to extend more credit. Increases in credit can turn a normal market into a booming market, and even into a bubbly market."
The securities should be viewed somewhat like nuclear power, he said, employing a metaphor similar to Buffett's.
"Nuclear power is great," Gerding noted. "But you better really understand the technology, and you better have all sorts of devices that check for potential human error."
Citigroup had securities with notional values totaling $55.6 trillion as of the first quarter, followed by JPMorgan Chase (JPM) with $52.4 trillion, Goldman Sachs (GS) at $52.3 trillion, and Bank of America (BAC) at $43 trillion.
A "small group of large financial institutions continues to dominate derivative activity," the Office of the Comptroller of the Currency noted in its first-quarter report on bank trading.
In the U.S., which has a market for credit-default swaps of nearly $2.6 trillion, according to the Bank for International Settlements, post-financial crisis reforms have attempted to curb the potential risk. The Dodd-Frank Act, for instance, requires that over-the-counter derivatives be traded through an exchange or clearing house, while setting collateral standards for those that aren't.
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