Thursday, September 15, 2011

Global Derivatives Watch: Netting, Collateral and Capital Cushions Matter

DerivMkt BIS Dec 87 Dec 10

In an attempt to demystify the derivatives markets, which have endured an abundancy of malign from both somewhat credible and uninformed critics, I have started to maintain a "Global Derivatives Watch" page HERE, with the intent of providing historical trends of these complex markets along with data analysis at regular intervals. Not only do I trade these markets (namely the options, futures and forex markets), but I see enormous value in derivatives to (a) hedge risks with a defined loss and (b) place bets with a defined loss, when structured properly and controlled with defendable margins and prudent capital controls.

The first fallacy that pervaded the derivatives markets, only to lead to the road to ruin for certain participants in these markets, was that there was ever such a construct as "risk free." Let me assure you that there is nothing of the sort. The second fallacy was that due diligence was not necessary on the derivatives counterparties with which a participant executes a trade, particularly of the sort that includes high leverage or risky collateral, and also particularly on custom over-the-counter (OTC) contracts that don't trade through a clearinghouse or on an exchange. Most equity, futures and forex options and forwards trade on exchanges and have benefitted from the transparency and liquidity. Nearly half of all interest rate swaps (IRS), the largest derivatives market by almost an order of magnitude over all the others in terms of gross market exposure, are cleared through a central clearinghouse, where netting and collateral control can be verified. To be sure, there are many specialized, one-off OTC derivatives that will still be executed between parties directly or through a dealer, but that doesn't minimize the importance in netting, monitoring of underlying or backing collateral quality and value, and capital cushions should a trade go south. (The poster child for failure to execute these tenants is AIG, which should have never been bailed out for its incompetence and risk mismanagement.)

As I like to say, derivatives don't bankrupt people, people bankrupt people. (Sound familiar?)

As the chart above shows, the derivatives markets have grown exponentially over the last two decades, signifying the demand for the ability to hedge and define risks. Much of this demand is due to heightened risks in markets that result from uncertainties in macroeconomic factors, such as interest rate risk, foreign exchange rate risk, systemic default/credit risk, and futures curve (commodity price) risk. Though the credit default swaps (CDS) markets have taken the brunt of the criticisms from an array of punditry, and have spawned one too many sensational bestsellers filled with overblown rhetoric, these instruments do serve a purpose in hedging both macro and microeconomic risks, particularly specific to securities, indexes of securities, companies, institutions and governments.

Just so I don't come off as a rep for one of the industry or lobby groups for derivatives, I will provide my own criticisms of the derivatives markets thus: not everything is known about these markets to gauge systemic stability in the event of gross risk shocks (dislocations) that in turn might bring about market liquidity issues (i.e., selling panic) and lead to serious market degradation and inadvertent losses. Of particular interest is the study of interest rate swaps when rates correct markedly higher or experience extreme volatility, as a result of market panic and inviting more market panic. Understanding the vulnerabilities in markets (not just derivatives, but also equity and debt/bond markets) is valuable and the role of market transparency, disclosure and visibility critical to the task.


No comments:

Post a Comment