The house of cards in derivatives

"Risk. Investors seem to love it," says Hamish McRae in The Independent on Sunday. Investors are ignoring safer assets, such as Government debt, and pouring into equities or junk bonds. The "dash for trash", as John Plender in the FT dubs it, has been fuelled by the global-liquidity glut, a result of the long period of unusually low interest rates in Europe and the US, along with surpluses in Asia and the oil-producing countries of the Middle East. The global money supply is growing at an annual pace of more than 8%, says Liam Halligan in The Sunday Telegraph, and the surge of the past few years is due also to the burgeoning market in derivatives complex instruments, based on a wide variety of financial assets, essentially designed to hedge risk.

The market is now worth eight times world GDP (about $480 trn), and has created so much liquidity that it seems to explain why the cost of borrowing in financial markets has remained low even though central banks have been raising rates for two years: "now, new-fangled financial instruments create liquidity independent of central bank control", says the think-tank Independent Strategy. Take the booming debt-derivatives market, says the FT's Gillian Tett. It has boosted demand for debt assets, pushing up prices and keeping corporate funding costs low. "In this credit cycle the derivatives tail is not simply wagging the dog but walking it around the block".

Derivatives: no-one is sure of the level of risk

Many argue that derivatives, notably credit derivatives, have allowed risk to be dispersed through markets, making them more resilient to shocks and less volatile. But as the market is so large, complex and opaque (much of the activity occurs in unregulated hedge funds) and mathematical risk-management models are "widely acknowledged" to overemphasise the "low volatility of recent times", as Richard Beales notes in the FT, a crisis on the scale of the LTCM collapse in 1998 can hardly be ruled out. Zhu Min of the Bank of China says that in Asia, "people have no idea" how much derivatives risk they are taking.

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Nor is there a clear idea of the leverage in derivatives although Tett cites an anonymous email from a senior banker describing how leverage levels of 50 are common, so an investment by a hedge fund in a credit-derivative package of e1m would be backed by just e20,000 of equity. As Richard Lander says on Citywire.co.uk, "one puff of wind" from the wrong direction a change in risk perceptions as the US falls into recession is just one possibility and the "whole house of cards" could tumble down.