Derivatives

Derivatives are financial instruments that were created to reduce risk, and their use on Wall Street is known as hedging. In recent years, however, as their prevalence and complexity ballooned, they created new kinds of risk and played a major role in the meltdown of the world's financial system. Republicans and Democrats favor measures to rein in their use, but the details of any proposals have become a major point of contention in the financial regulatory reform bill being developed in the Senate. With billions of dollars in fees at stake, financial institutions have launched a major lobbying effort to block proposals they see as too restrictive.

In December 2009, Democrats in the House passed a bill that would regulate derivatives and push most of their trading into clearinghouses meant to protect both parties to the deal from a default by the other. The bill passed in May 2010 by the Senate goes farther, including a provision that would force some of the biggest banks to spin off their trading in swaps, the most lucrative part of the derivatives business, into separate subsidiaries, or be denied access to the Federal Reserve's emergency lending window. The banks oppose that provision, and the Obama administration has also said that it sees no benefit, raising questions about whether it will survive a conference committee.

The name "derivative'' comes from the fact that their value "derives" from underlying assets like stocks, bonds and commodities.

One of the easiest ways to understand derivatives is to consider an early example -- farmers and traders in Chicago in the 19th century buying corn futures. A contract that guaranteed a certain amount of corn at a certain price at a date in the future helped reduce the risk posed by events like drought or floods that could cause sharp swings in prices. But that future also had a value in and of itself, one that rose and fell with the price of corn -- when corn prices went up, a contract for corn at a cheap price was worth more. So futures came to be traded as avidly as the commodities they covered.

The most common types of derivatives are futures; forwards, which are futures traded outside of a regular exchange; options, which are the right to buy or sell something at a specified date and price; and swaps, contracts involving an exchange of assets or payments.

In recent years, a bewildering variety of derivatives have been developed. One kind that played a central role in the financial crisis are credit default swaps, which are in essence a form of insurance policy, and whose value swings with the fiscal health of the transaction or asset it is written to cover. Swaps and other derivatives were often sold and resold in ways that attenuated the link between a party who created the thing of value being covered, and helped disguise the level of debt financial institutions were taking on. In the later stages of the housing boom, credit default swaps written in reference to mortgage-backed bonds were themselves bundled into financial instruments, known as synthetic CDOs, or collateralized debt obligations. Investors buying CDOs were essentially placing a wager on whether bonds held by someone else would turn a profit or fail.