The writer is a former banker and author of “Traders, Guns and Money” and “A Banquet of Consequences Reloaded”
In recent financial crises, derivatives have amplified and propagated losses in markets. They are now posing risks again but there has been a shift in the underlying nature of them.
Vulnerabilities in the financial system have emerged, ironically, through some well-intentioned initiatives to reduce risk. Since the 2008 financial crisis, there have been moves designed to reduce the level of credit between counterparties in markets.
The new regulations penalise so-called over-the-counter trades, deals conducted privately between parties, which are not secured by collateral. They also interpose “central counterparty clearing” or CCPs on more trades, requiring them to be processed through independent houses.
The system requires traders to post initial and subsequent margins, or collateral, to cover current mark-to-market and potential future losses. As much as 80 per cent of OTC trades, depending on type, now use CCPs. If bilateral collateral is included, a high portion of the $12tn of current exposure to derivatives (based on fair market values after netting positions) is covered.
Such moves have implications. Rising use of collateral creates liquidity risk. Sharp moves in prices result in large cash calls to meet current losses and higher initial margins due to increased volatility.
In recent months, commodity traders have been forced to seek additional credit lines or government support to cover collateral needs. Substantial moves in interest rates and currencies have affected investors using derivatives to hedge long-duration liabilities, as seen with UK pension funds.
Such scenarios raise the prospect of counterparties being unable to find the necessary collateral and then defaulting. In turn, this may trigger asset sales, transmitting price changes across markets. When positions have to be closed out, subsequent price moves can be exaggerated and participants left unhedged. At a time when overall monetary conditions are tightening, increased collateral calls absorb liquidity more broadly, too.
Higher collateral requirements also are one factor in the declining use of derivatives for genuine risk management, increasing overall systemic vulnerabilities. They add to other deterrents to the use of hedges by companies such as the complex accounting rules for them. The fair market value of derivatives that are not compliant with the rules must be separately reported in accounts, resulting in unwelcome earnings volatility. On interest rate hedges, some parties might also be deterred from using them after the shift away from the use of Libor as a benchmark for debt pricing. This transition has created potential mismatches between the benchmarks used on underlying borrowings and derivatives.
With genuine hedging demand stagnant, derivative activity has shifted towards speculative applications that increase risk. Key users are hedge funds, wealthy individuals and small to medium-sized enterprises which are less concerned about accounting treatment and disclosures.
Such counterparties often use exotic options that magnify leverage and risks by increasing gains and losses from a given event, such as small price moves or remote events.
And with some structured derivatives — sold with esoteric names such as targeted redemption products, accumulators, auto-callables — customers, knowingly or not, take on additional risk often without an identified worst case. These products have repeatedly caused problems in the past resulting in losses, expensive litigation and penalties for banks selling them.
Another systemic vulnerability arises from industry consolidation since 2008. This has meant most market segments are now dominated by a few players, typically large dealers and investors, restricting trading liquidity and concentrating risk. The growth of CCP and clearing houses, which aggregate counterparty credit exposures, further localises exposure.
In addition, as clearing is a product that is largely undifferentiated between providers, there are adverse incentives for industry players to undercut each other on required margins or default fund contributions, undermining the integrity of the system. Mutualisation of risk also creates moral hazard. Strong firms find themselves forced to bear the liabilities of weaker clearing members. In 2018, losses on energy futures positions traded on Nasdaq consumed around two-thirds of its mutual default fund. All this means that the risk of derivatives — the wild beasts of finance or weapons of mass destruction — remains a “known unknown” in a future financial crisis.