A Derivative Should Be Transparent and Easy-To-Understand
Financial derivatives are being virtually demonized, since many consider them responsible for the economic crisis. Credit derivates are especially held responsible for bank insolvencies, through the creation of a sophisticated system for the packaging, transfer, and multiplication of financial risks.
Such a system enabled banks to significantly expand credit (often to undeserving borrowers) without ultimately having to take on the credit risk associated with the loan, thus creating disincentives for monitoring debtor behavior.
A further example is the case of derivatives purchased by local administrations, also in Italy, which are accused of having caused losses so great that in certain cases they have jeopardized the very solvency of the administration in question. In these circumstances, it's hard not to bandwagon with those asking for drastic limitations on or outright prohibition of the use of derivatives. Yet such temptation should be resisted, and the benefits of these instruments should be coolly appraised. Derivates are effective tools of financial risk management (of interest rate, exchange rate, credit risks). As such they are useful not only for banks and other financial intermediaries, but for non-financial companies, and even administrations.
In order for the recourse to derivatives to be virtuous, two conditions must be met. The first is a clear illustration of the features of a given derivative and the coverage it provides, along with the additional risk it imposes down the road on either the issuer or the buyer. The simpler and more linear the structure of a derivative is, the higher the probability of reaching a correct valuation of the worth and risk of said derivative. Much of the recent damage caused by use of derivatives stemmed from their excessive complexity, which made valuation difficult even for market professionals.
The second condition is a healthy dose of transparency. In the current situation, the near totality of financial derivatives are traded in bilateral over-the-counter transactions, rather than on regulated markets. As a consequence, detailed information on the positions of market players is not available to the market, and the main source of information on actual operations is the one provided by operators themselves on their balance sheets. But a quick glance at the financial statements of the main US and EU banking groups reveals how scattered and lacking such information is. Only in recent months, after the financial crisis exploded, we have started seeing detailed analyses on the debt exposure associated with derivatives, classified by type of instrument, counterpart and maturity. The lack of transparency on the actual positions on derivatives of chief market players made uncertainty a lot worse after Lehman Brothers went bankrupt, significantly contributing to the factors causing a freeze in interbank and credit markets. Stronger transparency, it should be emphasized, should also apply to the use of derivatives by public administrations. It is advisable and should be required.
More scrupulous compliance with the two principles of simplicity and transparency would make derivatives beneficial tools of risk management, instead of scary "weapons of financial destruction".