City: Deals without frontiers

OVER the past six months, a substantial number of UK investment funds have used so-called 'cap and collar' transactions to lock in the performance of their equity and bond portfolios. It's a way of hedging against the possibility that gains seen so far this year might be wiped out by a sudden correction, and it's big business for the banks that act as counter parties.

Some of these transactions involve extremely large sums of money; almost all of them take place 'over the counter', which means that they are largely outside the control of any regulatory authority.

Most of the time neither the Stock Exchange, the Securities and Investments Board, nor the Bank of England (nor their counterparts in overseas markets) even get to hear about them. The same can be said of an awful lot of what goes on in the derivatives markets.

Moves are afoot to tighten up on supervision, but even so, derivatives will remain a largely unaccountable field of commercial endeavour - unmonitored and unregulated.

Since the mid 1980s, trade in derivatives has seen explosive growth, and they are now a key part of any investment bank's armoury. The numbers are becoming frighteningly large. In some financial markets, the tail is beginning to wag the dog: trade in derivatives is much larger than the physical markets on which they are based.

The purpose of derivatives is to hedge against risk - some of the potential upside is given away in return for protection against the downside - and there aren't many professional market players, fund managers or corporate treasurers who don't use them extensively these days; given the chance, most of them will wax lyrical for hours about what wonderful inventions they are.

However, a growing band of organisations and individuals are beginning to express concern. Last week, the Bundesbank added itself to the list. The Bank of England is openly more relaxed than other central bankers (see opposite), but that may owe more to London's key position in derivatives trading than anything else; the City would have a lot to lose if these markets were curtailed.

In its monthly report, the Bundesbank argued that derivatives trading had led to an interlinking of markets, undermining stability and making them much more vulnerable to crisis. Some go further. They see in the spiralling growth of derivatives the ultimate doomsday scenario: the possibility of total financial meltdown.

To the professionals who design derivatives and trade in them, this is all so much scaremongering, self-interested claptrap. The regulators don't like derivatives trading, they argue, because it falls outside their sphere of influence and because they don't understand it. Where there is ignorance, there is fear.

The same goes for the Bundesbank, they say. It is opposed to mushrooming derivatives trading because it can't control it, because it wants to determine interest and exchange rates throughout Europe, and because the free operation of markets runs counter to this aim. And finally it is because sophisticated derivatives trading is largely a New York/Chicago/London-based enterprise in which Germany as yet has little role.

There's plenty of truth in this analysis, but the idea that derivatives trading reduces overall risk in financial markets and indeed makes them less vulnerable to crisis - as its keenest supporters suggest - is plainly daft.

There's no such thing as a free lunch and there's certainly no such thing as risk-free investment, however much you might like to believe in it.

For the houses that know what they are doing, the risks are presumably quantifiable, but what if they are trading with someone who doesn't? What happens in a crash, for instance, if the counter parties, who may not be quite so clever, have over-exposed themselves and can't deliver? In those circumstances all the hedging becomes worthless. The point is that no one really knows what the dangers are because no one has an overall picture of what's going on. There's no chief croupier in charge of the casino.

If the balance of the betting is broadly neutral, there's no damage. But what if it is all strongly one way, which it may be, and the underlying markets move in the opposite direction? Then the gearing effect might be horrendous.

No one, except perhaps Hans Tietmeyer at the Bundesbank, wants to see these new markets undermined or discouraged. For international companies and finance houses attempting to plan against the vagaries of the currency and money markets, they are already far too useful a tool. But we need to know a lot more about them before it can be stated with certainty that there's not some vast new black hole being created out there.