Derivatives are insurance contracts which one party can sell to one another party (aka “counter-party) which protects against significant losses for a specific financial security.
The article points out that the simplest form of a derivative is home insurance. A homeowner purchases home insurance to protect against significant losses on the value of their home. Similarly, during the credit boom investors could purchase derivative contracts to protect against losses in the mortgage-backed bond investments they were making.
In the early part of this decade many (including Warren Buffett) called into question the concentration of risk around such derivative contracts. At issue was the fact that so many of these derivative contracts were being issued by the same financial institutions (i.e. AIG, Bear Sterns, etc.). If a catastrophic event were to occur they did not have the capital to back all of their commitments.
Unlike home insurance the derivatives market is unregulated so the buyer of the contract is left to do their own due diligence regarding the financial strength of the derivative issuer. In 2003 Greenspan and other “free market” proponents advised congress to pass a law to keep these securities unregulated arguing that the market would be able to properly price risk.
However, as we now know this is not the case. It is true that derivative contracts play a crucial role in the management of risk. However, we may want to re-think whether or not these contracts should come under the oversight of a government regulator.