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Even though derivatives clearly increase market volatility, Wall Street seems to be rushing headlong into financial cyberspace, where few traders, or their bosses, have ever gone before. Many of the derivatives that have raised concern are those based on untested mathematical formulas developed by so- called quants, short for quantitative analysts, who are rapidly gaining ascendancy in the trading rooms of banks and securities firms. But their computerized risk-assessment models, which monitor global transactions on a moment-to-moment basis and tell the quants when to buy or sell to balance vast portfolios, are based on historical patterns that cannot foresee all the worldwide selling pressures that could build up in a crisis.
Such unknowns could throw billion-dollar decisions, and even the financial soundness of the firms that make them, right back into the laps of executives who could find themselves ill prepared to deal with what the rocket scientists have wrought. "These mathematical models, they are not dealing with statistically definable facts that can tell you with certainty that if a market moves this amount, this is precisely what will happen," acknowledges Stephen Friedman, the chairman of investment-banking giant Goldman Sachs. "In the last analysis, you need to have people with common sense who can understand enough of what the rocket scientists are saying to translate it up the line," says Friedman, whose firm earned $2.7 billion before taxes last year, more than any other firm on Wall Street. "When there is a crisis, I want to have someone, like one of the heads of our fixed-income departments, sitting there at the trading desk with his shirt stuck to his body with sweat and interpreting for me what the rocket scientists are saying."
There were actually sound business reasons for the rise of derivatives, which first became popular in the 1980s. Money was moving around the globe like never before. The demise of communism in Europe expanded markets for American investors in countries such as Russia, Hungary and Poland. On the other side of the world, China lurched toward free enterprise. At the same time came the liberalization of economic policies in Latin America from Chile to Mexico and the rapid growth of the newly industrialized countries of Asia's Pacific Rim. The world was suddenly ravenous for American capital.
But American corporations and other prospective investors faced risks ranging from exchange-rate fluctuations to possible political coups. To underwrite the hazards, Wall Street began issuing over-the-counter derivatives contracts, which investors snapped up as security blankets. Such deals could be as simple as an agreement to buy German marks in six months' time at today's prices, or as Rubik's Cube-like as a single contract that covered the purchase of European bonds together with the sale of several foreign currencies and the acquisition of an option to buy U.S. dollars.