Q+A-Derivatives: What they are and why they matter

NEW YORK (Reuters) - The Obama administration has proposed exerting new government authority over derivatives, a largely unregulated multi-trillion-dollar market whose excessive risk-taking and poor oversight have been blamed as key drivers of the global financial crisis.

Treasury Secretary Timothy Geithner called on Wednesday for legislation to require many derivatives to be traded on exchanges or clearinghouses, rather than over-the-counter (OTC). He also wants users of derivatives to have enough of a capital cushion to protect themselves and the markets if something goes wrong.

Banks and dealers have opposed greater regulation, which could make it more costly to issue and trade derivatives, and thus reduce earnings.

But making the market less opaque could reduce the risk of wide damage, including from exotic instruments such as the credit default swaps that drove insurer American International Group Inc (AIG.N) to the brink of collapse in 2008.

Warren Buffett in 2003 famously labeled derivatives as "financial weapons of mass destruction." (Even at that, the billionaire investor uses some derivatives himself.)

Here are some basics about derivatives:

WHAT ARE DERIVATIVES?

Derivatives are contracts whose value depends on the underlying value of something specific, such as a stock, bond, currency or commodity. Examples are futures, options and swaps. A derivative is often designed for an individual customer's needs, and thus could later prove hard to trade unless some other party shared those needs.

In a typical trade, two parties exchange cash flows over months or years. Sometimes one party posts collateral. But because a single party could trade with thousands of others simultaneously, it is hard for any one party to know in an OTC market how much overall exposure someone else has.

Derivatives are a means to reduce or transfer risk, or limit the potential for sudden surprises as a result of changes in such things as interest rates, currency values and commodity prices. Airlines, for example, can use derivatives to lock in fuel costs, as some did ahead of last year's oil price spike.

HOW BIG IS THE DERIVATIVES MARKET?

It depends who is asked and which markets are included.

The Bank for International Settlements (BIS), which serves central banks, said there were $683.7 trillion of derivatives contracts in the middle of 2008, including for commodities, credit, currencies, equities and interest rates.

The International Swaps and Derivatives Association said there were $450 trillion of OTC derivatives at the end of 2008, including for credit, equities and interest rates.

The U.S. Office of the Comptroller of the Currency (OCC) said U.S. banks had $193.6 trillion of derivatives in the fourth quarter of 2008.

These sums represent potential exposures, not the value of the derivatives themselves. The BIS estimated the market value of derivatives at $20.3 trillion -- a still substantial sum roughly 50 percent larger than U.S. gross domestic product.

HOW DID OTC DERIVATIVES HELP CAUSE THE FINANCIAL CRISIS?

The Commodity Futures Modernization Act, which won substantial bipartisan support before U.S. President Bill Clinton signed it into law in 2000, left much of the U.S. derivatives market unregulated.

For most of this decade, this was not a problem, because many derivatives functioned as intended so long as markets remained relatively liquid. But the U.S. housing downturn and tightening of credit markets in 2007 caused many investors to lower risk, and reduced the liquidity of many derivatives.

Much of the trouble related to credit default swaps, essentially a type of insurance that a company will pay its debts, and which at its peak was a more than $60 trillion market. AIG's exposure to the swaps led to a series of federal bailouts and a $99 billion loss in 2008.

WHY DO REGULATORS WANT TO BOOST REGULATION OF DERIVATIVES?

Regulators worry that banks' exposure to OTC derivatives threaten the financial system. There is concern that the failure of any large dealer could unravel derivatives that the dealer has with other parties, causing losses to cascade throughout the financial services industry.

If this happens credit markets could seize up, essentially repeating the events of September 2008, when Lehman Brothers Holdings Inc (LEHMQ.PK), the investment bank and a major party in derivatives contracts, went bankrupt. This could also choke off efforts by central banks and policymakers worldwide to lift economies out of a global recession.

WHO GAINS OR LOSES FROM INCREASED DERIVATIVES REGULATION?

Winners include exchange operators with clearinghouses, such as CME Group Inc (CME.O), IntercontinentalExchange Inc (ICE.N) and London-based LCH.Clearnet. CME specializes in currency, equity and interest-rate products, ICE in credit default swaps and LCH.Clearnet in interest-rate products.

Britain's ICAP Plc (IAP.L) and other inter-dealer brokers such as GFI Group Inc (GFIG.O) could benefit if centralized clearing brings new participants into the market.

Losers may include big banks that deal in derivatives. The OCC said four are linked to 94 percent of derivatives on U.S. bank balance sheets: JPMorgan Chase & Co (JPM.N), Bank of America Corp (BAC.N), Citigroup Inc (C.N) and Goldman Sachs Group Inc (GS.N). Brokers that depend on arranging trades among dealers by telephone could also struggle, analysts at Keefe, Bruyette & Woods Inc said.

(Reporting by Elinor Comlay, Jonathan Spicer, Jonathan Stempel and Dan Wilchins; Editing by Tim Dobbyn)