Lehman Gets Piece of All the Action

With any kind of credit derivative, the Wall Street firms that make a market for these exotic financial products exercise tremendous control over pricing. But critics say the situation is particularly problematic in a new market, such as the one Lehman is trying to build for PCDS.

"Pricing on these instruments is difficult to model,'' says Tavakoli. "This is an illiquid market, and there will be a problem the minute there is a bump in a road.''

A hiccup in the market for PCDSs is probably of little concern to most retail investors. The main buyers, sellers and traders of PCDSs and other credit derivatives are hedge funds.

But regulators are increasingly concerned that, given the explosive growth in credit derivatives, hedge funds are overlooking the risks associated with these products.

The Federal Reserve, for instance, has been particularly concerned about the unbridled growth of the credit-derivatives market and has been working with banks and brokers to bring more clarity to this esoteric business. One thing the Fed is concerned about is the possibility of a systemic meltdown in the sector in the event of a major market selloff.

Much of the growth in the credit-derivatives market has come in the past three years, as stocks have headed higher and corporate defaults have neared all-time lows. In 2001, for instance, total trading in credit derivatives was less than $1 trillion.

The problem is, no one knows how things will shake out in this relatively new market when stocks head south and corporations start defaulting on their bonds.

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