Risk of derivatives not gone but simply morphed

MARKETS have served a timely reminder of the latent risk from derivatives - the wild beasts of finance.

Ten years after the collapse of Lehman Brothers Holdings Inc, almost to the day, a private trader and one of Norway's richest men suffered 114 million euros (S$182.5 million) of losses on energy-futures positions traded on Nasdaq.

The default ate through around two-thirds of Nasdaq's mutual default fund, using up several layers of protection. Members of the clearing house must now make substantial cash contributions to rebuild that cushion.

Given derivative-market and counterparty credit risk of US$13 trillion, the losses were relatively small and the risk was contained. Yet the event nonetheless raises concerns about the system's ability to withstand defaults by one or more major market participants, for which losses could potentially be much greater.

At their 2009 Pittsburgh meeting, the Group of 20 introduced central clearing for derivatives to mitigate systemic risk, reduce the threat of contagion, and improve transparency. The key element was the so-called central counterparty, which would assume the credit risk between traders and guarantee the performance of derivative contracts.

Despite its best intentions, the G-20 created a system that doesn't eliminate risk, but rather concentrates it into new, too-big-to-fail entities. The incident in Norway isn't isolated: LCH.Clearnet and the Korea Exchange clearing houses have both experienced defaults.

Central counterparties use a default waterfall - a sequence of financial resources - to cover exposure to unmet financial obligations in case of default. Upon entering a contract, all traders post an initial margin as a guarantee of performance.

The contract is then marked to market daily, or more frequently, to establish gains and losses, which must be covered by additional margins.

If a counterparty fails to meet a margin call, its positions are closed out, with the pool of already-provided deposits applied to its losses. If the amount held is insufficient, the clearing house covers losses from three possible sources, in a prescribed order: its own capital; contributions from non-defaulting members; or assessments against clearing members to inject additional funds.

The hierarchy of risk-bearing resembles the loss-absorbing capital layers in a collateralised debt obligation, the problem child of 2008.

The reliance on central counterparties is problematic in several respects.

Meanwhile, a major shock can increase the exposure to several major counterparties simultaneously. Taken together, the ability of non-defaulting members to bear losses may be lower than expected. Even single counterparty limits, designed to avoid concentrated exposure, are imperfect, as Norway's case highlights.

In the 10 years since Lehman's failure, policymakers eagerly have pointed to initiatives that, they believe, made the financial system safer and a repeat of 2008 unlikely. That view is excessively optimistic.

They lacked the courage to take necessary actions: restricting derivative activity to hedging, which would decrease market size; insisting on rigorous risk controls; eliminating conflicts of interest; and ensuring high levels of expertise among market participants and regulators.

As a result, the problems posed by derivatives never really went away. BLOOMBERG