What it means
Derivatives are contracts whose value depends on an underlying asset, rate or index, and they are used to hedge risk or to speculate. The total face value, called the notional amount, of derivatives outstanding worldwide is enormous, far larger than the size of the global economy.
The warning behind the phrase is that this scale makes the system fragile. The concern is not the size of the notional amounts themselves, since most contracts largely offset each other.
The worry is how connected institutions are to each other. If one large firm fails to pay on its contracts, its counterparties may suffer losses, which can spread to others in a chain reaction.
The phrase was popularised by investor Warren Buffett, who described derivatives as financial weapons of mass destruction in a letter to shareholders. His point was that the contracts are hard to value, easy to hide and can create large obligations far in the future.
Others disagree and argue that derivatives, used properly, make the financial system safer by spreading risk. Since the 2008 financial crisis, regulators have introduced rules to reduce the danger.
Many standard contracts must now be cleared through central clearing houses, and firms must post collateral, which is cash or assets pledged as security. These steps make it easier to see exposures and limit the damage from a single failure.
For business leaders, the practical lesson is to understand any derivative they use. Simple hedges that match a real exposure, such as a currency forward covering a known invoice, are very different from complex contracts that nobody in the company fully understands.
Accounting and disclosure also play a role in how visible the risk is. Many derivatives are recorded at fair value on the balance sheet, but the notes to the accounts may contain much of the detail on exposure and counterparties.
Finance staff and analysts should read those notes, because the headline profit figure may not show how much risk sits underneath.
In practice
Real-world examples.
Example
A regional bank discovers that a trading desk has built up large positions in complex contracts that were not fully reported to senior management. The risk team orders an immediate review and sets strict position limits.
Example
A manufacturer enters a complex currency contract to save $50,000 in upfront costs. When the exchange rate moves against it, the contract produces a loss of $1.2 million, and the finance director learns the contract had unlimited downside.
Example
A regulator runs a stress test on the largest banks, assuming one major counterparty defaults. The test shows which banks would lose the most, and several are asked to hold extra capital.
Formula
Calculation
Derivative leverage ratio = Notional amount / Capital
Suppose a financial firm holds derivative contracts with a total notional amount of $2,000,000,000 and has capital of $100,000,000. The leverage ratio is $2,000,000,000 / $100,000,000 = 20 times. If a market move causes losses equal to 5% of notional on one-tenth of those contracts, the loss is $2,000,000,000 x 0.10 x 0.05 = $10,000,000, which is 10% of the firm's capital.Case study
Seen in the real world.
Dunmore Capital is a fictional trading firm, used here as an illustrative example. Over several years it builds up a large book of interest rate and credit contracts, and its leverage quietly climbs to 30 times capital.
When interest rates rise unexpectedly, the value of many contracts moves against Dunmore at the same time and its counterparties demand extra collateral. The firm cannot raise cash quickly enough and has to sell assets at a loss, which damages other firms holding similar positions. Regulators later require firms to report leverage more openly, and Dunmore's story is used in risk training as an illustration of how hidden exposure can build up.
After the episode, Dunmore's new risk chief introduces a monthly report that sets out leverage, the largest counterparties and what would happen under a severe market move. She sets a hard limit of 15 times capital and requires the board to approve any exception. The firm's profits are lower in the years that follow, but its owners accept the trade-off for a more stable business.
Watch out
Common mistakes.
- Reading the notional amount as the amount at risk. The real exposure is usually a small fraction of notional because contracts offset each other.
- Assuming all derivatives are dangerous. Simple hedges are widely used by ordinary businesses to reduce risk.
- Believing the risk went away after 2008. Rules improved transparency, but derivatives remain large and connected, so vigilance is still needed.
Questions
People also ask.
Who first used the phrase?
The warning is most associated with Warren Buffett, who described derivatives as financial weapons of mass destruction. Other commentators have used the time bomb image since.
What reduces the danger of a derivatives blow-up?
Central clearing, collateral requirements, position limits and regular stress testing all help. Clear reporting and strong internal controls inside each firm are equally important.
Should small businesses worry about this?
Mainly in so far as they use derivatives themselves or depend on banks that do. They should only use contracts they fully understand and that match a real business exposure.
From the founder's library
Take it further with the book.
Build your financial confidence beyond this definition. Shihan's full-length guide, Accounting Fundamentals, takes the same plain-English approach and turns it into a complete, practical playbook for non-finance managers, business owners and students - with chapter-end quiz answers and presentation slides included.
25% off with code MMHQ25, applied at checkout. Priced in USD - checkout may show the equivalent in your local currency.
View the book and save 25%Related