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Investors could purchase these contracts directly from such dealers as Merrill Lynch or J.P. Morgan, or the dealers could arrange for swaps between investors; either way, the dealer got a fee. Such transactions could take place anywhere. A Texas manufacturer with a $1 million fixed-rate loan who suspected that interest rates would soon fall could swap the loan with a Michigan company that had taken out a floating-rate note but was worried that rates were headed higher. The Texas firm would be the loser if rates did rise, since after the swap it would hold the floating-rate note that called for larger interest payments. "The fundamental advantage of derivatives is that they let you buy the risks you want and hedge the risks you don't want," says Columbia's Greenwald, "and that's an extraordinarily useful function."
This also helps explain how derivatives can be both conservative and highly speculative investments. Because there are two sides to each transaction, one party can pass along the risk he does not want to a speculator who will gladly take it. Such trades can often turn on fraction-of-a-point changes in currency rates or interest charges. "The speed of money is faster than it's ever been," says Laleen Doerrer, the co-founder of a one-year-old Chicago derivatives firm. "It seems like every day someone has created a new contract and a new swap option. We are almost equally divided between two groups of customers -- one that wants to protect everything it has and the other that wants to make a 200% killing overnight."
These breakneck deals are possible because Wall Street today has transformed itself into a virtually seamless network of computer-linked brokers, dealers and exchanges around the globe. It is no longer (if it ever really was) defined by the canyons of buildings surrounding the New York Stock Exchange near the southern tip of Manhattan. The trades take place in an electronic neverland that can be entered from anywhere in the world. Billion-dollar transactions involving derivatives or other securities that once took hours or days to handle are now routinely completed in seconds -- with all the potential risk or reward that comes with instant gains and losses.
Chicago trader Peter Dunne, who works and sleeps to the sound of bond futures markets buzzing from Frankfurt to Tokyo, can attest to the global expansion of derivatives trading in the past four years alone. Dunne's working day has lengthened four hours over that stretch: he rises at 4:30 a.m. to get to the Chicago Board of Trade by 6 a.m. to begin the business of trading that can last until 9 p.m. The trading day for stocks and bonds has grown to marathon proportions as well. Sophia Ulanday, who sells U.S. stocks for Lehman Brothers in Hong Kong, begins her workday at 7 a.m. and frequently toils until 1 a.m. to stay in touch with the home office in New York.
With banks and brokerages striving to create ever more exotic derivative products, it is hardly surprising that the markets have begun to show signs of overheating. "Some of the dynamics are too fast for the fastest players," says Doerrer. Concurs Bruce Hauptman, a Fairfield, Iowa, money manager who handles $800 million in derivatives investments: "You're going to have people getting blown out, and there is going to be bloodshed."