It is human nature to be fearful or apprehensive when confronted with new ideas. Thousands of years of evolution have taught us to be suspect of new things. But for many on Wall Street, when an unknown is accompanied by high returns, greed sometimes trumps human nature.
Greed is good, says Gordon Gekko. After all, greed and fear drive investing. While greed helps drive a bull market, fear usually ends the fun. But fear, a basic survival instinct, has been repressed by some investors: "What is a collateralized debt obligation (CDO)?" asks one investor. "Who knows?" says another. "But the returns are unbelievable." While there are many on Wall Street who thoroughly understood CDOs, far too many investors knew too little about the instruments, the underlying financials or the market in which CDOs were supposed to actually reduce risk.
Now we are seeing fearless (perhaps reckless?) investors jump into other unknown markets. Many institutions have set up energy and weather derivatives trading desks. Again, these aren't exactly well-understood instruments. In fact, one of the challenges for these funds is actually finding people who not only understand the products, but also know how to trade them, since close to 80 percent of energy derivatives are traded off exchanges directly between banks. And weather derivatives (essentially hedges based on warmer or colder weather), which are growing at more than 25 percent a year, are even more complex -- banks often employ meteorologists to help their weather traders. If traders don't fully understand the instruments, how can they weigh the risks?
Perhaps most alarming, a majority of these trades are conducted via instant message directly between banks in the interbroker market. While vendors typically are all too happy to offer solutions to such arcane processes -- peer-to-peer network YellowJacket, for example, has created a business by organizing instant messages and linking them to trading tools for funds, hedge funds and interdealer brokers in the OTC energy and weather markets -- the current manual processing of energy and weather derivatives only adds to an already complex risk equation.
IM organization notwithstanding, it seems a small dose of fear would do some energy derivatives investors a bit of good. While too much fear can paralyze the decision-making process, a healthy balance of fear and risk taking just might help avoid the next market crisis.Greg MacSweeney is editorial director of InformationWeek Financial Services, whose brands include Wall Street & Technology, Bank Systems & Technology, Advanced Trading, and Insurance & Technology. View Full Bio