Derivatives for Dummies

Implications: This article, published last week's Economist, is the first article purporting to explain the global credit derivative market that I have read which isn't full of algebraic formulas.

It is a cogent and clear primer on derivatives and would be helpful to investors, clients and portfolio managers who are not yet familiar with derivatives. 

In addition to explaining how derivatives are structured, their purpose in the fixed income markets and their past and probable impact on risk management, the article offers significant food for thought on whether derivatives will do their job (i.e. mitigate the impact of credit defaults) when the bond market tanks.

Analysis:
This article is important for anyone working in the finance industry that uses derivatives as a credit hedge or to short certain corporate credits because the authors raise fresh issues that will certainly impact the demand for such instruments and the "approach" taken by most regulators /auditors in assessing or valuing derivatives as part of a portfolio review.

While derivatives clearly dissipate risk by dispersing it among many more parties other than the bond issuer and original investors, this may not be such a good thing.  As more "ring-fenced" special purpose vehicles are created providing investors with even more assets to purchase, the possibility that somewhere along the line, responsibilities are diffused and when massive defaults eventually happen, all parties involved simply point fingers at each other, either literally or via litigation, instead of accepting their "medicine" and moving on.

In essence, the global credit derivative market creates a huge pool of liquidity (see the article's chart illustrating the tremedous growth of this market over the decade) that is outside the purview of any central bank.  Is this a good thing or a bad thing?  I'll leave it to you to decide.