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They can also be dangerous, and that is their paradox. For while they were created to diminish risk, they can introduce more because of the sheer volume of money that rides on them. These side bets pull with them a real world of securities worth 30 times their value. Experts worried about the perils of such instruments have no trouble coming up with bleak scenarios. For instance, a utility company, trying to protect itself from an expected rise in oil prices, borrows lots of money to buy a derivative contract that will enable the firm to purchase oil in three months at current prices. But the price of oil goes down unexpectedly, and the utility is stuck with a commitment to buy oil at the higher price. That results in a big loss because the company not only has to pay more for oil than its competitors but also loses much of the money it borrowed to place the bet in the first place. The utility's stock plunges, leaving investors high and dry.
Even worse is a scenario in which one institution's troubles spread through the system. While that nightmare may be less likely than the first, it is the one that most experts are concerned about. Example: a major U.S. bank that deals in derivatives thinks it has covered all its bets around the world. But an unforeseen event, such as an earthquake in Tokyo or a coup in Latin America, sends markets crashing in some area. The bank's finely tuned hedging strategy is thrown off balance, and it has no choice but to default on its contracts. A whole chain of interlocking obligations snaps, setting off a series of uncontainable defaults that shake the world financial system. The remaining stock markets plunge, companies go bankrupt, and lots of people lose their jobs.
What inspires such worst-case speculation is the unprecedented size of the derivatives balloon. Its growth has prompted some Wall Street sages to warn that many of the newfangled instruments could be spinning far beyond anyone's control. The Jeremiahs include investment banker Felix Rohatyn, 65, one of Wall Street's elder statesmen, whose son Nicolas, 33, runs a J.P. Morgan department that uses derivatives to transact business in emerging markets in Asia, Eastern Europe and Latin America. "There's a whole different world in off-balance-sheet transactions that are potentially quite dangerous if people don't know what they're doing and a chain of financial commitments breaks down," says the elder Rohatyn. "These are interlocking commitments of trillions of dollars. As long as they remain solid and stable, everything is fine. But what do you do if something goes wrong?"