Date: Thu, 17 Mar 94 19:41:27 PST
From: RISKS Forum <risks@csl.sri.com>
Subject: RISKS DIGEST 15.66

RISKS-LIST: RISKS-FORUM Digest  Thursday 17 March 1994  Volume 15 : Issue 66

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Date: Tue, 15 Mar 1994 11:03:05 -0800
From: Phil Agre <pagre@ucsd.edu>
Subject: Derivatives

The new issue of Fortune contains a long article about the potential risks
of derivatives, which are complex types of financial deals that depend on
the values of certain underlying assets, such as currencies, commodities,
or composite entities like stock indexes.  The full reference is:

  Carol J. Loomis, The risk that won't go away, Fortune 129(5), 7 March
  1994, pages 40-57.

At the moment, there exist outstanding derivatives contracts on assets whose
total value is about $16 trillion dollars, about 2.5 times the United States'
GDP.  The problem is that nobody really understands how derivatives work.
They only exist in the first place because of big computers and global data
networks (see Risks 14.87).  In theory, they allow firms to manage the risks
of global business by hedging against potentially damaging fluctuations in
commodity prices, interest rates, currency exchange rates, and so forth, and
this can be a good thing.  In practice, it is difficult to do this right.
Moreover, the nature of derivative contracts entails increasing levels of
interconnection in the world financial system, with the solvency of each major
player frequently contingent on the ability of numerous other players to make
good on complex contracts.  A serious misjudgement at a large bank, on the
order of the savage losses recently incurred through bungled oil-price hedging
at the German firm Metallgesellschaft, could conceivably propagate through the
entire system.

It actually gets worse from there, as Loomis explains at some length.
Regulation is nearly nonexistent, largely because nobody knows how one *could*
regulate such things.  Reporting requirements are derisory as well.  In short,
the global economy is wound up real tight.  To be sure, market forces are
bringing an urgent profusion of risk management strategies.  The big question
is whether the prudence of individual players is adequate to prevent the total
system from collapsing in case of some exogenous event, or simply because
there's an angle nobody figures out until it's too late.

Phil Agre, UCSD

PS. The same issue of Fortune contains some advice for companies wishing to
engage in commercial activity on the Internet.

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End of RISKS-FORUM Digest 15.66
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