Financial markets are now much larger and many transactions are much more complex, making the risks associated with them harder to understand. Derivatives – the biggest growth area – are a good illustration. While they enable many businesses to hedge risks which they formerly had to accept, they also allow others to take risks that they formerly could not.
Notably, derivatives can make it easier for some participants to engage in leverage – an old-fashioned activity which can greatly increase risk. The recent LTCM episode brought this out clearly and its near-collapse illustrated how market risks can be large enough to be systemic. Recent events also reminded us that in a globalised market place, financial instability will often come from abroad.