In its latest survey of the attitudes and expectations of players in the derivatives market, ratings agency Fitch found that while just about all respondents welcomed the central clearing of derivatives (96%), the potential for overregulation was cited as the top challenge facing the market.
Fitch notes that respondents to the survey, which included the top bank and broker CDS protection sellers and buyers, were generally surprised by the extent of the blame for the 2008/2009 financial crisis attributed to derivatives. Players felt that market commentators such as the media and politicians were confused over the differences between structured finance products such as residential mortgage backed securities (RBMS) – a fundamental vehicle for spreading the contagion of the US sub-prime housing debacle through the global financial system – and credit default swaps (CDS).
The latter function as a form of insurance, with protection sellers taking a premium from protection buyers in return for guaranteeing a debt of a third party, which might be anything from a company to a sovereign state. At an early stage in the CDS market protection buyers would have exposure to the debt they were seeking protection from, but as the market developed, CDS positions were traded in their own right and their value fluctuated with the likelihood of a default by the target entity. The value goes up as the possibility of default grows (since the expectation of a large payout to the holder of the CDS protection would naturally increase).
The CDS market shot to public prominence when it became clear that AIG, at the time the world’s largest insurance company, had overextended itself massively on CDS deals and required a $183 billion bailout from the US taxpayer. Since the vast majority of people were completely unaware of the CDS market, it astonished them to discover that the CDS market was valued in the trillions of dollars – and that companies like AIG were taking massive positions in it without implementing adequate controls for the risks they were taking on. However, to market participants who were and are deeply familiar with the CDS market, little of this was surprising. There was nothing wrong with the CDS market in their view, what was wrong was daft processes at AIG – and possibly at Lehman Brothers and so on. All of which goes to show that how things look depends pretty much on where you are sitting…
The survey found that respondents were generally quite pleased with the efforts that regulators were making to try to understand the CDx (credit default based) derivatives market. Many respondents expressed surprise at the extent of the growth over the last year of the sovereign CDS market in terms of volumes traded. Volatility was greater than expected as was the size of the spreads in the market.
When pressed, respondents did rate the impact of CDx on cash market volatility as at least important and some thought it was very important, which shows that dealers have some tangential awareness that the derivatives market relates to the real world rather than simply to flows of nested numbers on a screen.
Since the derivatives space is far and away the most complex part of the whole trading arena, the idea that regulators around the globe are all going to become familiar with the intricacies of trades is nonsense. What can and should be done is to force senior management to sign off on the risks being assumed by their organisations in the CDx space. The regulators could then come to a view on the potential impact of that liability, just as they would with any other liability. The basic idea is to drive responsibility to where it can best be carried, but don’t hold your breath waiting for regulators to become derivatives analysts.
Further information on the derivatives market and the Crunch:
- Dangers of Corporate Derivative Transactions, by David Shimko
- Credit Derivatives—The Origins of the Problem, by Eric R. Dinallo
- Managing Liquidity Risk in a Financial Institution: The Dangers of Short-Term Liabilities, by David Shimko
- The new emerging structure for derivatives, a blog post by Anthony Harrington
Tags: central counterparty , credit default swaps , derivatives , economic recovery , EU , regulation , transparency