A better understanding of OTC derivatives is vital to us all

A crisis in over-the-counter derivatives could lead to fear, panic and a meltdown of global financial systems. But it needn't be so. With better understanding of the risks, that could easily be prevented.

Fighting the fear through better understanding

The coming crisis in credit derivatives is predictable, just as the subprime problem was. The risks may be smaller than you think, but that may not matter.

In the past year or so, we have seen a 'contained' crisis in subprime mortgage debt morph into a global financial crisis. It has forced big banks to raise billions of dollars of fresh equity, and has put bank share prices into retreat. Some knowledgeable observers are now estimating that losses could mount up to over $1 trillion when subprime related losses are added to those that may arise from Alt-A or other mortgage loans.

A popular candidate for the next big problem is the 'over-the-counter' (OTC) derivatives books of the banks. Many articles have been written about how huge these exposures are, and how losses in this area may trigger an even larger crisis in the global financial system. A meltdown could happen, but if it did, it might simply occur because fear spins out of control, and the desire to stop doing bad business prevents the banks from doing any business at all. A frozen financial sector would create huge problems for the US and for the global economy, and may even trigger a depression. But it need not happen. As Franklin Delano Roosevelt once put it in the depths of the 1930's depression, "The only thing we have to fear is fear itself." Panic can be avoided, provided the risks are better understood and better managed.

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Risk on OTC derivatives is not easy to extinguish, and gets over-counted

The OTC derivatives market is vulnerable and is seen as the likely vector through which credit problems could spread rapid-fire, right through the whole banking system. The real risks in these OTC trades are not well-understood in the articles in the popular press. Frankly, the size of the risks are often miscounted and may be overstated and exaggerated by the mainstream press. For example, I have seen reports which talk about bank derivative exposures approaching $50 trillion.

Understanding the true risks requires diving into a level of detail which is deeper than most journalists, or the average readers of such articles, find comfortable. I want to ask readers of this article to bear with me, as we make a brief journey into complexity.

Let me start by defining two types of derivatives:

Exchange traded derivatives these are futures or options contracts traded on an exchange. Like all derivatives, they are contracts whose prices are DERIVED from the price of a physical commodity, or a financial instrument such as a bond. The important thing is what party is the contracting party. With exchange traded derivatives, the party that is responsible for honouring the contract is the exchange itself.

Over-the-Counter (OTC) derivatives these are contracts between professional counterparties themselves, such as two banks, or a bank and its corporate client, without an exchange in the middle.

This difference in contracting is very important when a risk gets traded or passed on. When a futures contract (or an exchange traded option) gets sold, the seller is 'off the hook'. Once he or his broker delivers the contracts, and payment arrangements are completed, the risk is extinguished and the new buyer becomes fully responsible for the contract. The old owner brings his risk to zero by selling out.

Risk transference and calculations are very different with OTC derivatives. Each contract stands alone as a separate legal obligation. And selling a contract does not normally extinguish the risk. The original contract must reach its maturity, and be settled according to the contract terms before the risk can be fully extinguished.

Let me give an example. Suppose Bank B buys an OTC derivative linked to oil prices from Bank A. And then later the same day, it decides to double its oil exposure, but this time it buys oil futures. To make the example fully congruent, let's assume that the futures bought by bank B were sold by bank A. A week later, the oil price rises, and the bank decides to take profits. It may then sell a same size oil derivative to bank C, and also sells the oil futures on the exchange. Again, we assume that bank C bought the oil futures.

So we have:

Bank A's derivative sold to bank B later, resold to bank C

Bank A's future..... sold to bank B later, resold to bank C

Now what accounting trail has been left from these two similar transactions? The OTC derivative will remain on bank B's books. In fact, it will have two transactions remaining on its books:

Long : OTC oil derivative (with Bank A)

Short: OTC oil derivative (with Bank C)

The netted out exposure to oil price risk may be zero, but there remains an oil-linked credit exposure which is now twice as big, because there is one on both the long and short side of the trade. Banks normally carry these risks until the maturity of the OTC derivatives contract, and the final settlement has been made.

We can compare this reporting of positions with exchange-traded instruments. In my example above, the exposure on the oil futures gets fully extinguished when the contract is resold. When exchange-traded positions have been sold on, there is neither an exposure to the oil price, nor is there any lingering credit exposure.

The key point is this: I believe the huge numbers for OTC derivatives risk that get reported for on the books of banks can be exaggerated. These big totals are mostly 'residual' credit exposures. I say they are exaggerated because in practice, banks have trades in both directions, long and short, with other banks. (That is, bank A may have many open OTC derivative trades with bank B. On some it will be making money, and on some it will be losing money.) These open exposures can be calculated, and netted out, leaving a much, much smaller net credit exposure on the net loss amount due. In other words, the banks will never have to pay the full amount of the OTC derivatives exposure they report, only the net loss amounts. And even those may be dramatically reduced when all the two-way business between the banks is considered.

Now here's where the threat of out-of-control fear becomes an issue. Suppose a major OTC derivatives player went bust, as Bear Stearns threatened to do in March. That would trigger an early forced-settlement of all those still unexpired OTC derivatives trades. In a mass default, various unhelpful and disruptive actions would be taken by parties aiming to protect their positions, and/or benefit from the chaos:

First, stronger counterparties (i.e. the defaulted-upon parties) would exploit the default mechanism used to determine the size of losses. They are allowed to close-off trades, and may use trade prices which are favourable to the defaulted-upon party.

Second, a sudden influx of these 'risk unwind trades' might unbalance the market in one direction or another, prompting a big price move. A good example was when Bear Stearns 'hit the wall' in mid-March. There was a big drop of over $100 in a few days in the gold price. Many believe this came about because Bear was forced to quickly unwind a big long position in gold. Those that were aware of Bear's big gold positions stood aside and saw it in the OTC market selling in size, would have let the price drop as the unwinding trades were done, since they did not want to 'get in the way of a desperate seller'. Others may have made money by anticipating the drop, and going short gold.

Third, a default by a major counterparty would trigger fears that more defaults are coming, and that the losses and price gyrations might trigger another bankruptcy. Most banks would be very unlikely to enter new trades unless prices were very favorable, or 'in the right direction' to reduce risks. This means that there would be a big freeze up in the liquidity of the OTC derivatives markets, just as there have been already in the credit markets.

Summary and conclusions

If a crisis hits, markets may react irrationally. Current reporting is not clear enough. And because of the nature of OTC derivatives, reports of aggregate OTC exposures may even overstate the actual risk. Unless better reporting is done, it will be easy to mis-comprehend the magnitude of a new problem when it emerges. With the recent experience in the subprime crisis, it seems likely that markets will naturally assume that any early estimate of the size of a credit derivatives problem, may be too small, and that later as it spreads the losses will get are bigger. This expectation, may serve to spread fears and magnify them, contributing to the vulnerability of the financial system.

The problem is that the OTC derivatives market is so enormous, and problems can spread very quickly through a chain reaction of defaults. The markets may over-react and/or be at risk of freezing up very quickly. Banks that today look 'too big to fail', may be deemed 'too big to save'.

Meantime, banks can reduce the size of potential problems, by improving risk reporting, and shifting some OTC risks to new exchange traded contracts.

The next few years will not be easy. Many markets, like housing in the US and UK, remain in bubble territory. Those asset values need to be allowed to deflate. But if banks reform themselves and their reporting in a way that helps to maintain confidence, then we may be spared prices moving in a fear-driven panic, where prices fall below sustainable values, and bring enormous damage to the global financial system.

By Michael Hampton, July 1, 2008. Visit his website at https://www.globaledgeinvestors.com/

Michael Hampton was a pioneer in introducing oil swaps, an OTC derivative, almost 20 years ago. He worked in product development for Chase Manhattan Bank at the time, and was a key member of the team that designed the oil swap. He later headed the team that successfully launched the oil swap product throughout Europe. He subsequently headed the commodity derivative business of another big global bank.