Financial innovation still threatens the system
Exotic financial instruments contributed to the financial crisis starting in 2007. Four years on, they are as potent as ever.
You often hear about the ambiguous role played by derivatives in finance. The value of derivatives depends on - or is derived from - other financial quantities such as exchange rates or share prices.
Yet these contracts are not by themselves the problem. The trouble comes from so-called 'synthetic finance' or 'replication'.
The idea of replication lies behind what might be called the founding myth of the derivatives industry, the Black-Scholes option pricing model.
Published in 1973, and leading to Nobel prizes for its creators, the idea of this model is that you can copy a derivative using simpler financial building blocks. If the derivative diverges in price from its replicant, traders can earn a free lunch by buying one and selling the other.
It's called arbitrage, and according to the theory it enforces a unique price for the investment in the derivative.
The point is not whether the theory is true. When derivatives first took off, in the 1990s, there were plenty of blow-ups when traders made mistakes or investors failed to understand what they were buying.
Even the inventors of the Black-Scholes option pricing model got caught out when their giant hedge fund, Long-Term Capital Management, blew up in 1998.
More insidious was how replication took over the culture of banking.
Locking out regulators
It was the seductive idea that if you want to invest in something that is difficult to buy and own - say a commodity like oil - you can do it synthetically.
Or if you are a bank that has reached its lending limits, you can synthetically get rid of loans that are clogging up your balance sheet. Derivatives happen to be the tool that makes this possible, and the richest and most powerful people in banking were those who understood the arbitrage.
By the mid-2000s, the mania for replication had led to entire banks being synthesised - so-called structured investment vehicles or SIVs were unregulated financial androids that would in effect take deposits and lend out the money, by buying mortgage bonds.
These technical innovations in the world of finance undermined some key foundations of financial markets, leaving regulators and ordinary investors outside the charmed circle.
Haves and have-nots
The idea is that the price of a financial assets is solely determined through supply and demand in a public market, such as a stock exchange for example. The idea is that the balance sheet of a bank tells you how exposed it is to a downturn.
But those on the inside track - like Goldman Sachs - were able to protect themselves. In 2001, the US bank used derivatives to help Greece disguise its debt ratios. In 2007 and 2008, Goldman used derivatives to protect itself from the disaster that engulfed other banks and forced them into the arms of taxpayers.
This division of finance into technical haves and have-nots made the whole system seem rigged and unfair.
It's one thing when an investment bank helps a company issue new shares or bonds. It's something else when they create a synthetic product that looks and feels like an investment in shares or bonds but isn't.
In these structured products, the issuing bank remains connected to the customer via a derivative for the lifetime of the product. Who's on the other side of the derivative? Is it the bank? If the customer loses out, they win. Do they know something that the customer doesn't?
A new breed
Tricky questions like that have got Goldman into hot water, although the bank denies wrongdoing. Other banks have been protected by small print disclaimers in their product contracts. Barclays, for example, recently defeated a claim in London's High Court by an Italian bank that claimed its practices amounted to fraud.
In fact, the big picture four years after the crisis began is not how the boom in synthetic finance has vanished, but rather how resilient it is. Although some of the worst innovations such as SIVs or CDO-squareds are no longer around, a new breed of financial androids has sprung up: high-frequency trading strategies that affect markets in unpredictable ways.
Meanwhile products such as exchange-traded funds (ETFs) are growing rapidly, fuelled by derivatives that allow investments to be replicated. Companies from carmaker BMW to commodities giant Glencore are heavily dependent on derivatives to protect their revenue figures.
The banks complain about new regulations, but derivatives and the culture of replication are too embedded in the system to disappear now. The advantages of being in the middle of these markets are just as lucrative as they were four years ago.
That is why another crisis is only a matter of time.
Nicholas Dunbar is the author of the forthcoming book "The Devil's Derivatives" and "Inventing Money: the story of Long-Term Capital Management and the legends behind it".
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