The use of derivatives as a risk management tool is growing exponentially, according to the International Swaps and Derivatives Association (ISDA).

Derivatives have had something of a troubled past – the major rogue trading scandals of recent years, Nick Leeson at Barings Bank and National Australia Bank’s forex options incident have all featured derivatives, and legendary investor Warren Buffett called them ‘financial weapons of mass destruction – but ISDA reported growth in volume of outstanding privately negociated derivatives of 105 per cent in 2005.

While that growth was down from the 123 per cent growth of 2004, ISDA officials said firms from more industries and geographies are embracing derivative use. “Continuing innovation in the derivatives business is leading a larger number of firms from more industries and more geographic regions to embrace the use of these important risk management tools,” said Robert Pickel, chief executive officer and executive director of ISDA. “Since its inception in 1985, ISDA has fostered and enabled this innovation through its legal, documentation, netting, public policy, operations and risk management initiatives around the world.”

ISDA has established user groups to solve some of the problems with derivatives and share information. The focus is expected to be in credit derivatives, perhaps the most controversial.

That controversy is well founded. According to analysts fallen energy giant Enron used credit derivatives to inflate its balance sheets and hide substantial losses. On a basic level, a credit derivative is the same as purchasing insurance against potential losses - they allow a lender to hedge the risk of default. But more sophisticated derivatives, such as collateralized debt obligations (CDOs) transfer risk from a group of loans or bonds, often off the main balance sheet.

Regulators globally have held concerns over credit derivatives for some time. Fundamentally, the issue is how accurately and transparently they are reported by the firms buying and selling them. Additionally there are concerns that the companies investing in and selling the instruments may not be pricing risks correctly.

Australia’s credit derivative market remains relatively young compared with North America, but it is growing quickly in size and sophistication.