Operational risk and infrastructure failures have played a prominent role in past financial crises, and the infrastructure weaknesses that have characterized the credit derivatives markets since their inception are another credible source of concern.

In the case of the crude oil market, some observers have attempted to attribute at least part of the increase in oil prices over the past few years to the activities of hedge funds and other speculative traders.  The apparent increased participation of these traders in the market, however, does not mean that their actions are actually responsible for the price run-up.  In fact, increases in oil prices probably encouraged the entry of speculative investors in the market. It may also be the case that these market participants have added liquidity to the market and have faciliated the price discovery process at a time when the balance of supply and demand in the physical oil market has undergone significant change.

When innovation, such as we are now seeing in credit derivatives, takes place in a period of generally favorable economic and financial conditions, we are necessarily left with more uncertainty about how exposures will evolve and markets will function in less favorable circumstances.

And, with respect to their safety, derivatives, for the most part, are traded among very sophisticated financial institutions and individuals who have considerable incentive to understand them and to use them properly. The Federal Reserve's responsibility is to make sure that the institutions which it regulates have good systems and good procedures for ensuring that their derivatives portfolios are well-managed and don't create excessive risk in their institutions.

SEN. SARBANES: Warren Buffet has warned us that derivatives are time bombs, both for the parties that deal in them and the economic system. The Financial Times has said so far, there has been no explosion, but the risks of this fast growing market remain real. How do you respond to these concerns?

BERNANKE: I'm more sanguine about derivatives than the position you just suggested. I think, generally speaking, they are very valuable. They provide methods by which risks can be shared, sliced and diced and given to those most willing to bear it. They add, I believe, to the flexibility of the financial system in many different ways. And, with respect to their safety, derivatives, for the most part, are traded among very sophisticated financial institutions and individuals who have considerable incentive to understand them and to use them properly. The Federal Reserve's responsibility is to make sure that the institutions which it regulates have good systems and good procedures for ensuring that their derivatives portfolios are well-managed and don't create excessive risk in their institutions.

Derivatives, by construction, are highly leveraged, a condition that is both a large benefit and an Achilles’ heel. The benefits of risk dispersion are accomplished without holding massive positions in the underlying financial instruments. Yet, too often in our financially checkered past, the access to such leverage has induced speculative excesses that have led to financial grief. We are scarcely likely to reform the underlying human traits that lead to excess, but we do need to buttress our risk management capabilities as best we can to delimit such detours from the path of balanced growth.

More fundamentally, we should recognize that if we choose to enjoy the advantages of a system of leveraged financial intermediaries, the burden of managing risk in the financial system will not lie with the private sector alone. Leveraging always carries with it the remote possibility of a chain reaction, a cascading sequence of defaults that will culminate in financial implosion if it proceeds unchecked. Only a central bank, with its unlimited power to create money, can with a high probability thwart such a process before it becomes destructive. Hence, central banks have, of necessity, been drawn into becoming lenders of last resort.

All the new financial products that have been created in recent years contribute economic value by unbundling risks and reallocating them in a highly calibrated manner. The rising share of finance in the business output of the United States and other countries is a measure of the economic value added by the ability of these new instruments and techniques to enhance the process of wealth creation.

...This redistribution of risk induces more investment in real assets, presumably engendering a higher standard of living. This occurs because financial intermediation facilitates diversification of risk and its redistribution among people with different attitudes toward risk. Any mechanism that shifts risk from those who choose to withdraw from it to those more willing to take it on increases investment without significantly raising the perceived degree of discomfort from risk borne by the public.