The 0.6 Quadrillion Dollar Systemic Risk? Counterparty Risk in Global OTC Derivatives

London, UK - 6th June 2011, 21:25 GMT

Dear ATCA Open & Philanthropia Friends

[Please note that the views presented by individual contributors are not necessarily representative of the views of ATCA, which is neutral. ATCA conducts collective Socratic dialogue on global opportunities and threats.]

Remember the 0.6 quadrillion dollar problem* ATCA flagged a few years ago in regard to counterparty risk? Guess what, it is still there! The $600 trillion global Over-The-Counter (OTC) derivatives market is still broadly unregulated although a number of new rules for privately traded swaps -- the biggest part of that $600,000 billion dollars -- have been proposed by the two US derivatives regulators:

1. Commodity Futures Trading Commission (CFTC); and 2. Securities and Exchange Commission (SEC).

$0.6 Quadrillion Systemic Risk

Systemic Risk

The collapse of Lehman Brothers in September 2008 and the need for a bail-out of insurance group AIG immediately after that highlights the “counterparty” risks that buyers and sellers of private derivatives expose themselves to and what type of contagion and cascading systemic risk manifests itself when counterparty risk in the private derivatives market suddenly appears. Let us not forget that the two main root causes of trillions of dollars of losses in The Great Unwind (2007-?) and The Great Reset (2008-?) for investors and financial institutions around the world were:

1. Unrealistic assumptions about rises in property prices; and 2. Excessive lending to NINJAs or people with little or No Income No Jobs no Assets to repay their debts.

In parallel, let us not underestimate the role played by derivative instruments in exacerbating the scale of those great crises by significantly increasing leverage in the global financial system and enhancing the extent to which the world’s biggest financial institutions are closely coupled and diverse asset classes extremely correlated, thereby creating unprecedented systemic risk.

An International Monetary Fund (IMF) report recently quoted by the financial press on making Over-The-Counter (OTC) derivatives safer states the following in this regard:

“During the financial crisis, the credit default swap market, a part of the OTC derivatives market, took centre stage as difficulties in financial markets began to intensify and the counterparty risk involved in a largely bilaterally cleared market became apparent ... authorities had to make expensive decisions regarding Lehman Brothers and AIG based on only partially informed views of potential knock-on effects of the firms’ failures.”

Key Question

Since 2008, although sweeping changes to the world’s derivatives markets have been promised by both lawmakers and regulators across major countries, not much has actually materialised. G20 ministers have set a deadline for full implementation of reforms by the end of 2012 but what ATCA is being asked increasingly frequently by chairmen and chief executives of major financial institutions and shadow banking groups is the following: "What happens by way of counterparty risks in the derivatives market if the next global financial crisis comes before 2012?"

Complex Challenge

Although it would appear that the counterparty risk problem in OTC derivatives is being resolved, if truth be told, so far few rules have been finalised and there are growing calls for more time to revamp the enormous and complex privately traded "swaps" markets, which include:

1. interest rate swaps;
2. credit default swaps;
3. currency swaps;
4. equity swaps; and
5. commodity swaps.

The Dodd Frank Act

The Dodd-Frank act in the US aims to “improve the regulation of swap and security-based swap activities.” Unbelievable as it might seem, the US is the farthest ahead in the world in regulating such derivatives after the passing of financial reforms in July last year. "Dodd-Frank" creates a whole new regulatory structure for derivatives markets. However, it is vitally important not just to the US economy, but to the global economy, that American regulators get this new structure and underlying rules right. Regulators have already proposed hundreds of pages of new rules. The US has a near impossible deadline by which the new rules have to be written, ie, by July 2011, which is next month! Even if this deadline could be met -- although we doubt that it will -- it could still take a few years to implement those regulations fully. The reason for our doubt is that there is already a push in Washington DC to introduce legislation to formally extend the unrealistic July deadline for the derivatives rules to be written.

Conclusion

There is a high probability that a meaningful correction will take place in the closely correlated commodity and equity markets at some point in the near future before 2012. If such a correction takes place, cascading counterparty risks are likely to unfold in the global Over-The-Counter (OTC) derivatives market because of excessive leverage. Given that the new rules may not be in place for the $600 trillion OTC derivatives market before 2012, we have to be prepared for a repeat of the Lehman Brothers-AIG-type fiasco but this time it may not be contained within the United States and may have international dimensions involving other major powers like China, the European Union, Russia, India and/or Brazil. If more than one country is involved, even the mighty US Federal Reserve cannot step in to solve the problem on its own like it did in 2008. What happens if an entire country decides to protect its industry and declares the OTC derivatives contracts and obligations null and void, thereby triggering trans-national counterparty risks with unintended systemic consequences? China has already mooted such a possibility and therefore this scenario may no longer be farfetched. Certain recent events in the commodity markets involving OTC derivatives' counterparties in the Far East appear to suggest such a possibility. The counterparty risk associated with OTC derivatives needs to be watched very very carefully.

* ATCA References:

. Unintended Consequences of Printing Money in Trillions? - 8th November 2010;
. Derivatives Quadrillion Play: How Far Away Are We From A Second Financial Crisis? - 23rd March 2010;
. Quadrillion Playing Submerged Elephant in the Room! - 25th April 2009;
. G20 Summit must focus on Derivatives, Off-Balance-Sheet Vehicles; 8 Bubbles Quadrillion Play Grows 22% to $206k per person-on-planet - 19th March 2009;
. Bank Stress Tests, Liquidity Trap, Black Hole, Top Global Risks, Yen's Safe Haven, Japan's Exports, Live Poll, Obama - 26th February 2009;
. The Four Scenarios: Debt Deflation, Hyperinflation, Quadrillion Play and Muddle Through - 15th November 2008;
. The Eight Bubbles: What are the Numbers suggesting? - 8th November 2008; and
. The Invisible One Quadrillion Dollar Equation - Asymmetric Leverage and Systemic Risk - 28th September 2008.

[All available via http://www.mi2g.com/cgi/mi2g/media.php]

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