Derivatives may be losing steam

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The derivatives market, which helped to take down AIG (AIG) and Lehman Brothers, may finally be losing some steam. The Bank of International Settlements (BIS) reports that for the first time since data collection started, the derivatives market shrank in the second half of 2008.

The number of outstanding contracts linked to bonds, currencies, commodities, stocks and interest rates fell 13.4 percent to $592 trillion. That's the first decline in 10 years, which is when BIS started collecting the data. Interest-rate derivatives make up the largest part of that market. They fell 8.6 percent in the second half of 2008 to $418.7 trillion outstanding.

Other markets dropped even more sharply. Foreign exchange contracts fell by 20 percent to $49.8 trillion. Equity derivatives dropped 36 percent to $6.5 trillion and those linked to commodities fell 67 percent to $4.4 trillion.

Trading volume in derivatives is expected to drop even more when 2,000 banks, hedge funds and asset managers that trade credit-default swaps move the contracts to a clearinghouse and eliminate overlapping trades. Traders are canceling redundant default swaps to appease regulators and help reduce day-to-day payments and the potential for error. Until this happens no one will really know the true volume of trading today.

Last week, the Obama administration made it clear that they want to expand the regulations of derivatives. They are not the first to call for this regulation. In fact the first calls came from Brooksley Born, who fought for derivatives regulations a decade ago and lost. Had administrative officials listened to her at that time we may have avoided the current financial disaster we now face. Born believes that we must make changes now or "we will be haunted by our failure for yours to come." She said those words while accepting the Profiles in Courage award at the John F. Kennedy Library yesterday.

Lita Epstein has written 25 books including Trading for Dummies.
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