What’s the future for much-maligned derivatives?

Warren Buffett perfectly personifies the current conundrum with derivatives. On one hand, he has famously called them "financial weapons of mass destruction." Anyone who has watched mortgage-backed securities and the credit default swaps based on them spark the worst financial crisis in 70 years would have to agree.

On the other hand, Buffett owns derivatives himself. His Berkshire Hathaway had 94 derivatives contracts on its books as of Jan. 1, creating a liability of $6.4 billion for the company.

It's easy to understand why Berkshire Hathaway might want to hold derivatives. They aren't intrinsically evil. Lots of businesses, from farms to software exporters, use derivatives to protect against the financial risk inherent in their operations. An agriculture company might buy futures to protect against a price decline for its produce, while an exporter could purchase options to prevent a reduction in revenue if the dollar rises.

And speculators in the derivatives market aren't evil, either. Buffett himself appears to be a speculator rather than a hedger when it comes to his use of derivatives. Their presence is necessary to guarantee liquidity for everyone else-without them, others would have to pay more to buy and sell their futures, options, etc.

So, why is everyone so upset at derivatives?

Derivatives are in some ways very simple: They are securities whose value is based on an underlying asset. For example, mortgage-backed bonds are based on mortgages. You can buy, sell, or speculate on these bonds without ever touching the mortgages themselves.