How dangerous are credit derivatives?

April 27th, 2007

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A few months ago, in Prepare for asset repricing, warns Trichet, we reported that:

With such massive quantity of derivatives sloshing around the global financial market, there is very little wonder that no one, not even governments or central banks can fully understand what is going on.

Indeed, the growth of derivatives looks to be in an exponentially upward trend: Credit Derivatives Doubled for Third Straight Year (Update2). How dangerous is this development of modern finance?

According to the Reserve Bank of Australia (RBA)?s March 2007 Financial Stability Review, it has the following comments:

Rapid growth in the use of credit derivatives is also posing financial regulators with a number of issues relating to transparency. In some cases, the balance sheet data received from financial institutions are becoming less meaningful, as 15 credit exposures are taken on or divested through derivatives. The growth of credit derivatives markets has also meant that it is less clear where the credit risk actually resides, and how those holding this risk will react in a less benign environment…. This intersection of private equity, hedge funds and credit derivatives is rapidly transforming credit markets. This transformation is mostly for the better, improving the allocation of global capital, and leading to risk being more broadly held than in the past. Despite this, there remains considerable uncertainty as to how the system would react to a very large shock. It is possible that the very developments that have contributed to the increased robustness of the financial system to most events, through the wider dispersion of risk, could actually amplify the disruption following a serious shock. In particular, there is uncertainty about just how credit risk transfer markets, on which so many institutions now rely, might perform. Dealing with this potential paradox – a decline in the likelihood of a significant disruption but an increase in the potential costs of such a disruption – is likely to remain a key issue over the years ahead for central banks and financial regulators charged with maintaining financial stability.

Today, it has come to the point that the risk to the global financial system through the widespread use of derivatives is beyond the understanding and control of central banks and regulators. Furthermore, though derivatives make the chances of things going wrong less likely, the outcome is far worse when they really go wrong.

What does this means for us? It means that the conventional risk model uses by much of the financial industry cannot spot such dangers. That is why Warren Buffet said that ?Certain perils that lurk in investment strategies cannot be spotted by use of the models commonly employed today by financial institutions.? (see Myth of diversification as safety?Part 2: nature of risk).

Therefore, we see that hedging is still wise.