The controversial practice of derivative trading lies behind the JPMorgan Chase debacle, where more than $2 billion were lost recently in risky trading bets.
Chairman and CEO Jamie Dimon disclosed the losses and apologized to shareholders. He was able to hold on to his job, but now the Department of Justice is investigating the transactions that led to the bank's huge losses.
But few people really understand the purpose behind derivative trading and why it have become such a problem, both globally and for the individual investor.
Phil Kerpen, a policy analyst at Americans for Prosperity, a group promoting free markets, said that if you go back a few centuries, you'll find the origin of derivatives was innocent enough: farmers wanting to protect the price for their crops.
"A farmer in the field didn't want to risk it that when his crop came in, he wouldn't be able to get the price that he wants. He might go to a grocer and say 'let's agree that on this future date I'll sell to you for this price.' And that's what's called a forward contract," Kerpen said.
And the grocer would agree because he knew he would get as many crops as he needed that year at a guaranteed price.
So both the farmer and the grocer came out ahead: they already agreed on a certain price for a given amount of grain. So both were protected financially, even in case of a bad year for crops. Thanks to the contract, the grocer had his crops, and the farmer had his money.
The contract itself was the "derivative" because it was derived from something else: the crops and the agreed-upon price for them.
Not Assets, But Deals Made About Assets
So derivatives aren't actually assets, but deals made about assets. In many cases, they're just bets.
"Let's say you're in the oil business and you're going to sell a lot more heating oil if it's a cold winter," Kerpen explalined. "You might want to bet against a cold winter so that if there isn't one, you'll make more money that way and it'll smooth out your risk."
This hedging of risk is an insurance policy for both sides.
"Maybe you wouldn't go into a business if you had to assume all the risk," Kerpen said. "But if you can spread it through some of these hedging mechanisms, suddenly some economic activities that wouldn't happen do happen. So there's a gain to the overall economy."
Over time, the derivatives market exploded, from simple futures contracts for farmers to -- well, almost anything.
Farms to Stocks, Bonds, Commodities
There are all kinds of financial assets in the world - including stocks, bonds, or commodities like gold, oil, grains and so on. Today you can bet on all sorts of derivatives for almost any of them: whether their value will go up or down, how the weather might affect them, and so on.
And now -- with basically every financial firm, as well as regular businesses -- involved in all sorts of derivatives on a daily basis -- they number hundreds of billions of dollars.
Michael Mackenzie of the Financial Times points out there are frightening aspects to all this.
"The derivative market: it does scare people because people say, 'okay, these are huge amounts,'" Mackenzie said.
Some of the biggest derivatives traders are not nearly as regulated as ordinary banks and brokerages. And they make much riskier bets.
Mackenzie pointed out, "A hedge fund has much, much greater credit risk if you're trading with them."
They also borrow unbelievably large amounts of money in the hopes of making more and more profits using high leverage.
But the trade has grown so big and is carrying so much risky debt, that one of the world's savviest investors of all -- Warren Buffett -- labeled derivatives "financial weapons of mass destruction, carrying dangers that... are potentially lethal."
One of the biggest dangers is tied up in what's called counter-party risk, where several firms may be involved in one derivatives deal.
And that leads to a serious risk because, as Mackenzie explained, "if they fail, it's like a chain of dominoes. Once one person stops paying, then all these other trades that have built off that first trade are also under threat."
"A lot of these entities are going to go out of business," economic analyst Kerpen warned. "And their losses are so big, so they won't be able to pay the winners. The people who wrote these bets on the other side won't get paid. So there could be a major loss economy-wide if a lot of these entities start to fail."