Wall Street is quite jittery following the rapid disappearance of one of its largest and oldest brokerage firms, Bear Stearns. Bear Stearns management has agreed to sell the firm to erstwhile competitor JP Morgan. So far losses are limited to Bear Stearns shareholders, who have seen the value of their shares decline by almost $20 billion over the last year, about half of that in the last few weeks. But the rapid fall of such a venerable trading house has made everyone suspicious of their counterparties for financial transactions, and there is a general worry that a full-fledged liquidity crisis will occur: the very worry that buyers may not be found for certain assets leads people to put them up for sale, thus exacerbating the difficulty of finding buyers. This column will discuss one aspect of the crisis: to what extend are exotic financial derivatives, and the so-called "hedge funds" who favor them, responsible for this and other recent market crises? Are these instruments good for the market, or should their use be subject to greater regulation? From an ethical point of view, are the gains made by hedge funds and other derivatives traders made at the expense of other investors and the stability of the financial system? Derivatives are instruments that don't represent ownership of anything; rather, they represent a promise to pay a certain amount of money based on a particular outcome. The earliest derivatives are insurance contracts, which pay a sum (indemnity) to the insured contingent on a loss; a simple traded derivative is an option, where the seller promises to buy or sell a stock at a certain price. Value-investment guru Warren Buffett leaves no doubt about his opinion: he recently called these instruments "financial weapons of mass destruction". Traditional weapons are aimed at a specific target, but WMD's destroy indiscriminately. Buffett likewise believes that derivatives are a danger to the entire market. I would say there are two main cases against complex derivatives. For one thing they are a swindle. Making money by arbitraging these instruments doesn't contribute anything to the efficient functioning of the markets, it's just a way of swindling the less sophisticated investors. No less an expert than Richard Bookstaber, one of the great theoretical and practical pioneers of derivative finance, writes that "if hedge funds are able to extract differentially higher returns, someone else is paying for them with comparably subpar returns. Maybe it's you." Secondly, they are a danger to market stability because they are opaque and poorly understood, and may have unnoticed interconnections which could endanger market crisis. Newly-minted and poorly-understood "portfolio insurance" derivative schemes are considered by many to be one cause of the incredible 30 percent stock market crash in October 1987. Likewise, the securitization of high-risk mortgage securities was evidently poorly understood by traders, since some of the largest and most sophisticated banking firms in the world lost tens of billions of dollars in this market last year, precipitating a crisis which continues to plague the world financial system. As I have written previously, it's hard to understand what was hard to understand about these instruments. Far from being exotic derivatives, they were among the simplest and most transparent new securities being traded. This was really just a classic case of the "greater fool theory" failing big-time. I don't buy the first argument, that derivatives traders prey on traditional investors. The hedge funds' outsize returns are achieved the old fashioned way by finding mispriced securities. This is not at all the zero-sum game that Bookstaber describes; the game benefits anyone selling a security that is undervalued by traditional market participants but will be snatched up by hedge funds. Bookstaber himself ultimately acknowledges this, writing, "though vilified and demonized by many, hedge funds and other speculative traders are not gamblers or financial parasites . . .for the investor who must liquidate because of a margin call . . .the cumulative impact of the hedge funds and speculators can be the difference between staying in business and facing default." However, I do buy the second argument. There is a good reason that insurance and banks are heavily regulated. Whenever you are betting against infrequent events like floods, there is always the danger that insurers will take the money and run, and have nothing left to give customers come high water. So insurers have strict capital requirements. Some derivative strategies have similar dangers. Portfolio insurance works to insure any given investor against a market crash, but when it was adopted by huge numbers of market participants there was obviously not enough cash anywhere to indemnify the hundreds of billions of dollars of losses in the 1987 crash. We rely on banks to mediate virtually all of our financial transactions, so it is proper for regulators to ensure their soundness. Today, hedge funds supply much of the liquidity in the markets and have become in many ways bank-like entities. Free-wheeling investment funds should be better regulated. A good place to start would be to limit leverage. The most famous hedge fund blowup was that of Long Term Capital Management, which held assets valued at over $100b. despite a capitalization of only about $6b. Thus a relatively small fund was able to have a huge impact on markets. Limiting leverage a bit seems a fairly harmless safeguard towards preventing a financial Chernobyl. So I don't think the complex strategies of derivatives traders are inherently parasitic; on a day to day level they are "win-win" trades like most transactions in a free economy. But I do think that many strategies are inherently destabilizing in a crisis, and when unexpected events occur they can throw the entire market for a loop. The problem is aggravated because imperfect statistical models used by some firms deem fairly mundane events "unexpected". A little more oversight could greatly limit the danger presented by these strategies with relatively little impact on their positive contributions. [email protected] The author is a research director at the Business Ethics Center of Jerusalem (www.besr.org), an independent institute in the Jerusalem College of Technology.