Derivatives: Instruments of Mass Destruction?

Another day, another disclosure of a massive derivative loss. Given the astronomical amount of outstanding (OTC) derivative contracts (and even astronomers that are used to think in big numbers might have trouble relating to the relevant numbers) it is no wonder that these 'accidents' pop up on a regular basis. Low or non-existent capital requirements make these off-balance sheet exposures attractive for treasurers and CFO's. They require little or no cash up-front so give the somewhat false impression that entry to the great casino is free and profits will flow like manna from heaven. Sometimes they are sold as hedging instruments - and they might well be fit for the purpose but the iron discipline needed to stick to that narrow use is not given to all market participants. And many users are easy prey to the salespeople that are highly incentivised to peddle ever-more exotic schemes that resemble a 'heads I win, tails you lose' game. And given the fact that derivatives are ultimately a zero-sum game it is only natural that those offering these products are above all interested in making sure that they are not on the losing side of any derivative deal. Derivatives may well have a place in the arsenal of any financial market participant - but have to be supervised by experienced experts who can give an objective assessment of the risks and rewards involved.