No Going Back (Derivatives in the Long Run)

Abstract

Many of the difficulties during the credit crisis have been attributed to derivatives, particularly the use of credit derivatives in structured products built on sub-prime mortgages. Derivatives also played an important role in the leveraging and risk-taking process prior to the crisis. These were very difficult to unwind, and added to liquidity and credit problems. There are also ongoing concerns about settlement rules and counter-party risk in the market for CDS. A key concern is that when hedge funds and other net providers of credit protection default, their counterparties will be left without insurance against credit exposures. Of particular concern is the downgrading of bond insurers, putting at risk the cover on risky debt (via CDS contracts issued by these bond insurers) related to payments on collaterised debt obligations (CDOs). Nonetheless, there are also important differences of view. For example, some analysts have used the demise of Bear Stearns (and before that the collapse of LTCM) as an indication of structural weaknesses in the OTC derivatives market, while others argued that the OTC market had 'coped quite well' at a time of heightened price volatility. These opposing opinions can be explained to an important degree by the so-called risk paradox (section 2). The crisis raised also doubts about the effectiveness of risk management systems used by banks. Highly sophisticated banks were confident that their risk management system would be able to deal with market corrections. But risk management systems failed to anticipate the devastating effect of the loss of market liquidity, severely estimated banks' exposures, and the extent in which institutions would be affected by heightened market stress. Against this backdrop, I will assess in this paper the reasons why banks' business plans and risk management systems failed (section 3), as well as the required pre-conditions that need to be in place for fully benefitting from complex derivatives for the long run (section 4).

Keywords: derivatives, risk paradox, risk management

JEL Classification: G12, G13, G28, G32