Instead, after opening with a few words about corporate governance and the importance of trust and reputation and the benefits of derivatives in risk management, Greenspan served up two explosive warnings in code seemingly aimed squarely at derivative dealers themselves. Here is a translation that should be of interest to any market participant.

First, Greenspan cautioned dealers about concentration in the derivatives market, particularly in credit derivatives. He cited "the decline in the number of major derivatives dealers and its potential implications for market liquidity and for concentration of counterparty credit risks." He specifically mentioned concerns about credit default swaps–private contracts in which parties bet on an issuer's bankruptcy, default or restructuring.

Credit default swaps generally have been a boon for bankers. Just as banks used them in the late 1990s to hedge default risk in Asia and Russia, they did the same recently to deflect credit risk associated with Enron, WorldCom and the like. In industry parlance, banks have been net "buyers" of credit protection, meaning that they make payments on credit default swaps in exchange for the right to receive a payment in the event of default.

Banks hedged at least $8 billion of Enron risk through these swaps, and even more for WorldCom. That meant that when Enron and WorldCom defaulted, the banks could sit back and yawn. They might not receive payments on defaulted loans, but they would receive offsetting payments from "sellers" of default protection, their counterparties on those swaps. Greenspan previously had indicated that he was thrilled by all this hedging.

Of course, the hedging didn't make these risks disappear. Instead, credit risk was passed, like a hot potato, to less sophisticated players–primarily insurance companies and pension funds–that are sitting on hundreds of billions of dollars of losses. According to Fitch Inc., a rating agency, insurance companies sold $283 billion of default protection through credit default swaps. Recently, reinsurers have been abandoning their credit derivatives business, just as Warren Buffett unwound General Reinsurance's credit default swaps, the source of his derivatives woes.

What worries Greenspan is the decline in the number of players in these markets. As players exit, it becomes even more important that each remaining player stay in the game. Credit derivatives trading, like poker, is not fun with only a few players.

In his speech, Greenspan cited a single dealer that controls one-third of the market and a handful of dealers that split the remaining two-thirds. If one of those dealers failed, the derivatives markets might become illiquid, as they did during the Long-Term Capital Management fiasco. Even worse, that dealer might be the first of many dominos to fall. Imagine a poker game where everyone at the table is borrowing from everyone else. Now, suppose the biggest loser goes bust after losing a big bet with someone not at the table. Suddenly, all of the players at the table are insolvent.

The Dangers of Concentration

Most experts believe that the dealer of greatest concern to Greenspan is J.P. Morgan Chase, primarily because it does control so much of the market. (Greenspan didn't mention the bank by name.) The bank's 123-page annual report for 2002 lists $366 billion of credit derivatives in terms of notional value, the value of the underlying loans upon which the derivatives are based. Even the fair value of J.P. Morgan's credit derivatives–just a fraction of their notional value–is greater than the bank's combined investment banking fees and trading revenues for 2002, and more than that of any other dealer.

By comparison, Long-Term Capital Management had about 4% of J.P. Morgan's derivatives, and less exposure, yet the Federal Reserve was forced to engineer a bank-led bailout in 1998 because of concerns about systemic risks. Banking regulators obviously don't want to do that again. Consequently, Greenspan's implicit message is that derivatives dealers should be extra careful not to become too exposed to any one of their competitors.

Second, Greenspan urged dealers to disclose more information about derivatives. Financial institutions have lengthy footnotes chock-full of tables of financial data, including details about derivatives. But the hundred-page-plus annual reports are opaque, even to analysts covering the industry. Here, Greenspan's language was unusually pointed: "Transparency challenges market participants to present information in ways that accurately reflect risks. Much disclosure currently falls short of these more demanding goals."

For Greenspan, those are fighting words. He and his regulators apparently have been reading the latest round of impenetrable reports from financial institutions. If they can't understand what is happening at the big banks, who can?

J.P. Morgan's disclosures actually are better than those of its peers. The bank reports various risk measures, including "Value At Risk," which captures in a single number the firm's highest expected loss under certain assumptions. The bank also says it analyzes worst case scenarios using a sophisticated system called "Risk Identification for Large Exposures," better known as "RIFLE," although it fails to release its conclusions to shareholders.

Similarly, the bank reports that 945 of its derivatives assets and liabilities are valued based on "internal models with significant observable market parameters." It would be better if banks used only quoted market prices, but those aren't available in many derivatives markets. Moreover, "internal models with significant observable market parameters" are better than "internal models with unobservable market parameters."

The concentration and disclosure problems are related. Just as Long-Term Capital Management unraveled when its lenders finally learned of the daisy chain of deals that enabled the firm to borrow so much money at favorable terms, a derivatives dealer's network of contracts might similarly unravel when counterparties–or even shareholders–learn the truth about the dealer's mysterious web of transactions.

In the long run, greater transparency and competition should lead to greater market discipline. In the short run, they might lead to some spectacular failures. And that was on Greenspan's mind when he announced that he is no longer "entirely sanguine with respect to the risks associated with derivatives." The major dealers are fortunate that he didn't use one of his catch phrases instead. If he had, the derivatives markets might be melting down already.