The $300 Trillion Time Bomb

If Warren Buffett can't figure out derivatives, can anybody?

For hundreds of years, the way to solve problems in the financial market was clear: Get Wall Street’s titans in one place and knock heads. It took only 24 brokers gathered under a buttonwood tree to form what became the New York Stock Exchange. J. Pierpont Morgan locked several dozen bankers inside his famous library on Madison Avenue to solve the panic of 1907. And in 1998, New York Fed president William McDonough convened representatives from the biggest Wall Street firms, 14 of which then bailed out Long-Term Capital Management.

Less than a decade later, financial markets have become vastly more complex. And they are no longer in the hands of a select few. Markets are tied together in ways that regulators and even Wall Street professionals struggle to comprehend. Bonds are bound to stocks, which are tied to currencies around the world.

The binding threads are derivatives, and the brightest minds on Wall Street worry about how they work—especially as stock markets around the world hit a bump. The term derivatives describes an array of financial contracts whose value is deter­mined by, or derived from, an underlying asset such as a stock or currency. The deriva­tives market, one of the fastest-growing areas of finance, is estimated at $300 trillion. A subset of that—credit default swaps, which are derivatives based on com­panies’ creditworthiness—last year reached $26 trillion, twice the size of the U.S. economy.

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