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The Derivatives Mess March 02, 2006

Over the past year New York Federal Reserve President Timothy F. Geithner has become increasingly concerned about the use of derivative instruments as outlined in a few of his speeches and a number of largely unnoticed articles buried inside the Wall Street Journal. In a recent speech before the Global Association of Risk Professionals, Geithner stated that the widespread use of derivatives “have not eliminated risk” and “have not eliminated the tendency of markets to occasional periods of mania and panic. They have not eliminated the possibility of failure of a major financial intermediary. And they cannot fully insulate the broader financial system from the effects of such a failure…And there are aspects in the latest changes in financial innovation that could increase systemic risk in some circumstances, by amplifying rather than dampening the movement in asset prices, the reduction in market liquidity and the associated damage to financial institutions.”

Geithner stated that so far the expanded use of derivatives has taken place in a period of generally favorable conditions, but that “we know less about how these markets will function in conditions of stress, and the most sophisticated tools available for measuring potential losses have less to offer than they will with the benefit of experience with adversity.” He pointed out that the gaps in the infrastructure and risk management is most conspicuous in credit derivatives, where the measure of credit risk “may not adequately capture the scale of losses in the event of default in the underlying credits or the consequences of a prolonged disruption to market liquidity. The complexity of many new instruments and the relative immaturity of the various approaches used to measure the risks in those exposures magnify the uncertainty involved.”

As explained by David Wessel in the Wall Street Journal, the problem is that the derivatives market has grown so fast that it has overwhelmed the legal, technical and paper-work handling infrastructure. Under present conditions no firm can be sure who owes what to whom. According to Geithner, “The post-trade processing and settlement infrastructure is still quite weak relative to the significance of these markets…The total stock of unconfirmed trades is large and until recently was growing considerably faster than the total volume of new trades. The time between trade and confirmation is still quite long for a large share of transactions. The share of trades done on the available automated platforms is still substantially short of what is possible…firms were typically assigning trades without the knowledge or consent of the original counterparties. Nostro breaks, which are errors in payments discovered by counterparties at the time of the quarterly flows, rose to a significant share of total trades. Efforts to standardize documentation and provide automated confirmation services has lagged behind product development and growth in volume…the assignment problems create uncertainty about the actual size of exposures to individual counterparties that could exacerbate market liquidity problems in the event of stress.”

To his credit, Geithner began stressing the nature of the problems in late 2004. Former New York Fed president Gerald Corrigan organized an industry group to deal with the problem in early 2005 and the members have met a number of times since then to report on their recommendations, most recently on February 16. Despite reported progress there is still a backlog of thousands of unconfirmed trades, and about 40% of new trades are still not matched electronically. There’s still no centralized means of processing trades.

In our view the derivatives mess described above is another potential time bomb (among many) that could throw the financial markets into a severe crisis. In the last 30 years every period of monetary tightening has eventually led to financial crisis. These included the Penn Central bankruptcy in 1970; the Franklin National Bank failure in 1974; the First Pennsylvania bank failure in 1982; the Continental Illinois bank failure in 1984; the savings & loan crisis in 1990, the Mexican Peso crisis in 1994; the Asian, LTCM and Russian crises in 1998; and the bursting of the Nasdaq bubble in 2000. The derivatives market is a leading candidate to trigger the crisis on this cycle, although there are obviously many other candidates as well.