In the good years, the lightning-fast growth of credit derivatives was feted as a Wall Street success story. But since the credit crisis exposed the financial sector’s fragility, and the flaws in bank risk management, it’s starting to look ominous.
Credit derivatives outstanding grew 37% in the second half of last year alone, and covered some $62 trillion (Rs2,480 trillion today) of debt at year-end, according to the International Swaps and Derivatives Association (Isda), an industry group.
Since the collateralized debt obligations machine that gobbled a lot of default swaps was moribund at that point, most of the volume spike reflects attempts to hedge or bet on the credit market’s collapse.
Of course, that’s what credit derivatives are for. But the growth of the derivatives market overall raises troubling questions. This $455 trillion of contracts has bound the financial system in a web of counterparty relationships that could magnify and spread the fallout from small problems.
That’s because a derivative isn’t cancelled when it’s no longer wanted. Rather, a new mirror-image derivative is created to offset the first one. And banks also net off much of their exposures to different counterparties. So, out of that $455 trillion, the net credit exposure is a mere $2.3 trillion. That’s less than a bear-market decline in the Standard and Poor’s 500 index.
But that calculation assumes that everyone in the market makes good on their obligations—meaning no big traders such as Bear Stearns Companies Inc., or the monoline bond insurers, suddenly wink out of existence. Even the failure of a small market participant could gum up the works, as its counterparties scramble to figure out whether they have just taken on, or shed, a bunch of risk.
Banks take steps to cover their exposures, principally by demanding collateral. But according to Isda, 37% of non-listed derivatives are not subject to collateral agreements. Also, the declining value of loan collateral has been a big driver of the credit crisis. Such a scenario could play out in the derivatives world, too. If so, those soothing net exposure assumptions would prove illusory.