NEW YORK (HedgeWorld.com)–A commissioner of the Commodity Futures Trading Commission acknowledged last week–and replied to–the concerns of the financier Warren Buffett and others that financial derivatives constitute a ticking time bomb on the contemporary global financial and economic scene.

In keynote address delivered to a conference on derivative-based investments, sponsored by Institutional Investor, Sharon Brown-Hruska provided the customary disclaimer that her views were her own, not necessarily those of the CFTC or its staff.

She then launched upon a history of financial derivatives and their increasing acceptance. She began with the collapse of the Bretton Woods agreement and its system of fixed currency exchange rates, in 1971. The collapse of this agreement led international banks to begin offering forwards and arranging parallel loans, developments that Ms Brown-Hruska described as the precursors to currency swaps.

She brought her capsule history to the present day, and to Congress’s hearings about the reauthorization of the CFTC. In the course of these deliberations, she said, “questions have been raised regarding the regulatory effectiveness of the [Commodity Futures Modernization Act of 2000] and concern has been expressed over the explosive growth of the derivatives markets.” In this climate, Mr. Buffett’s worries in particular have resonated.

She considers the worries ill-founded, though. What Mr. Buffett may not fully have considered, she said, is that “prescriptive solutions … will not likely lower credit risks or increase liquidity, will not decrease volatility, and will certainly not lower prices (which is the desire of energy market critics); however, constraining or curtailing derivative market use through these measures may lower market quality and ultimately drive up the cost of using derivatives.”

Then she noted that some of Mr. Buffett’s concern is with the underlying credit risks that build up when derivatives move into the money (or out of it, for the counterparties) rather than with the instruments themselves. The clearinghouse, and the settlement of contracts on a daily basis, minimizes the credit risk insofar as derivatives are bought and sold on exchanges. But what of the credit risk arising from over-the-counter transactions?

Here, too, though it’s a more difficult question for her, Ms Brown-Hruska doesn’t share Mr. Buffett’s concerns. “The International Swaps and Derivatives Association and the Managed Funds Association have developed a set of best practices and put forth sound mechanisms to clear [this risk] up,” she said. “I believe that such cooperative efforts under the guidance of a regulator demonstrate the constructive role that a regulator can play in working with market players to prevent problems before they occur.”

The energy derivative markets, in particular, she contended, have been blamed for the bad pricing news of recent years, when they have only delivered the message. “Earlier this year, economists at the CFTC completed a study of trading by managed money traders in the energy markets,” she said. “What they found, contrary to the charge of critics, was that these traders tended to provide liquidity to large hedgers. They react to the demand for hedging services, creating a buffer to price movements rather than causing them to move excessively.”

Ms Brown-Hruska, summing up, said that although regulators can’t abandon their mission of protecting consumers and the markets themselves, they can’t become “intransigent so as to stifle legitimate business innovation.”

Before becoming a regulator, Ms Brown-Hruska taught derivatives, risk management, and private capital market finance at George Mason University, and before that, at Tulane University.

CFaille@HedgeWorld.com

Contact Bob Keane with questions or comments at bkeane@investmentadvisor.com.