In the early 1990s, when central banks first began to take interest in them, experts told us that derivatives enabled risks to be unbundled and shifted at a low cost to those who were most willing and able to bear those risks.1 Given the diversity of risk preference among economic agents, the new distribution of risk after derivatives transactions was regarded as welfare enhancing.
Furthermore, as a result of better distribution of risk, it was claimed that the whole financial system should become more resilient. Conceptually, this argument made sense, but in practice, there were spectacular mishaps. Our intuition, based on such experiences, tells us that not all financial innovations are created equal.