The Vast Proportion of Derivatives Are Custom-Made (Not Standardized) and Sold ‘Over-the-Counter’ (OTC) by Banks

There was a time when most such derivatives were standardized instruments produced by exchanges like the Chicago Mercantile, which has pioneered the market for weather derivatives. Now, however, the vast proportion are custom-made and sold ‘over-the-counter’ (OTC), often by banks which charge attractive commissions for their services. According to the Bank for International Settlements, the total notional amounts outstanding of OTC derivative contracts — arranged on an ad hoc basis between two parties — reached a staggering $596 trillion in December 2007, with a gross market value of just over $14.5 trillion. Though they have famously been called financial weapons of mass destruction by more traditional investors like Warren Buffett (who has, nonetheless, made use of them), the view in Chicago is that the world's economic system has never been better protected against the unexpected.

The fact nevertheless remains that this financial revolution has effectively divided the world in two: those who are (or can be) hedged, and those who are not (or cannot be). You need money to be hedged. Hedge funds typically ask for a minimum six- or seven-figure investment and charge a management fee of at least 2 per cent of your money (Citadel charges four times that) and 20 per cent of the profits. That means that most big corporations can afford to be hedged against unexpected increases in interest rates, exchange rates or commodity prices. If they want to, they can also hedge against future hurricanes or terrorist attacks by selling cat bonds and other derivatives.

—Niall Ferguson, The Ascent of Money: A Financial History of the World (New York: Penguin Press, 2008), 227-228.