An enormous new financial business that could trouble even the Federal Reserve Board and yet defies the understanding of the nation's best financial minds is terrifying governments around the world while also earning billions of dollars for the United States.
It is a business--called derivatives because it deals in new securities and agreements \o7 derived \f7 from underlying stocks, bonds and commodities--that can be said to help finance Medicare and keep your mortgage rate reasonable, while offering opportunity for your mutual fund.
It is also a business that deals in an incredible $15 trillion worth of securities, loans and interest rate swaps, putting a total of $600 billion at risk.
Those numbers frighten most people, including lawmakers in Washington who would regulate derivatives if only they could get a grip on what they are.
On the other hand, Susan M. Phillips, a governor of the Federal Reserve Board, sees the growth of derivatives as part of the evolution of financial risk management that began with the deregulation of interest rates in the 1970s and moved on to the mortgage-backed securities that helped save home mortgages in the 1980s.
To Phillips, an economist who has served as a commissioner of the Commodity Futures Trading Commission, interest rate and currency swaps are the latest examples of the know-how that keeps U.S. firms on the cutting edge of global finance and earns the United States a tidy surplus in international trade in services.
In their simplest form, derivatives enable a small business that can borrow only short-term at fluctuating interest rates--which expose it to the risk of rates moving up--to trade its interest payment schedule with a large business that has long-term loans at fixed rates but wants the lower, short rates because it can withstand the risk of fluctuation.
Typically, through a swap contract drawn up by a commercial bank or investment company, the small business pays the big fellow's fixed rate of interest, and the large firm, which in effect has refinanced its debt, pays the lower, short-term rates.
The banks and finance houses, which verify the credit-worthiness of both parties and work out the actuarial risks of the swap transaction, make big money as intermediaries. Goldman Sachs, the Wall Street investment bank that is a leader in derivatives, has just reported a profit increase of 82% to $2.7 billion for 1993; Citicorp, the big bank that only two years ago was a candidate for Federal Reserve rescue, recently reported a '93 profit of $2.2 billion.
