A 9 Fold Increase in Credit-Swaps Derivatives in 3 years, That's substantive. this article illustrates a potential
systemic weakness in the Financial System.
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Fed, Will Meet Over Derivatives August 25, 2005
By HENNY SENDER, MICHAEL MACKENZIE and RAMEZ MIKDASHI
Staff Reporters of THE WALL STREET JOURNAL
August 25, 2005; Page C3
The Federal Reserve Bank of New York will meet with Wall Street banks next month to discuss the still relatively opaque market for credit derivatives.
The market is a young but rapidly growing one where traders and investors use the derivatives to buy and sell protection against defaults. Trading volumes have soared, but back-office functions needed to make sure trades get completed haven't kept up with that growth.
It is these so-called settlement issues that the New York Fed wants to discuss with the bankers on Sept. 15. New York Fed President Timothy Geithner sent a letter to dealers on Aug. 12 inviting them to meet on "how best to address a range of important issues in the credit-derivatives market."
While those issues appear technical, they are essential to keep losses from snowballing into more systemic problems when the markets are volatile.
In May, for example, a downgrade of General Motors Corp. debt sparked violent moves in the market for credit derivatives and at least paper losses for Wall Street firms and the hedge funds on the other side of some trades. Those events led to calls for greater discipline and monitoring. More recently, problems surfaced when car-parts company Collins & Aikman Corp. filed for bankruptcy protection. A daisy chain of trades made it hard for many in the market to figure out who their ultimate counterparty was.
According to the International Swaps and Derivatives Association, the notional value of credit-default swaps outstanding reached $8.4 trillion at the end of 2004, a ninefold increase in just three years.
The New York Fed invited 14 banks from the U.S. and abroad but declined to name them. The credit-derivatives market is dominated by a handful of banks, including J.P. Morgan & Chase Co., Deutsche Bank AG, Morgan Stanley, Goldman Sachs Group Inc. and Citigroup Inc. Goldman Sachs and J.P. Morgan declined to comment, while other banks couldn't be reached for comment.
Hedge funds account for much of the recent surge in credit-derivatives activity. Banks welcome the funds as trading partners, but the funds sometimes move out of trades -- "assign" them -- without telling the bank that sold them the credit-derivative contract that their counterparty has changed. This makes it harder for other participants to know whether their positions are properly hedged.
Questions about the rising backlog of trades that haven't been settled have been with the market for some time. Indeed, the issues the Fed raises in its letter have been flagged by regulators in the United Kingdom and most recently in a report last month from the Counterparty Risk Management Group led by Gerald Corrigan, a former New York Fed president.
Federal Reserve Chairman Alan Greenspan and others have praised the role of the derivatives market in diluting financial risk, although the central-bank chief did warn in a speech in May of the potential risks to the economy if the use of derivatives isn't properly managed.
Banks and even some hedge funds say they welcome the Fed's initiative because it will help them focus on how to beef up their own back-office functions.
"We've always thought issues surrounding confirmations, settlements and assignments were really important, and have ourselves invested a great deal of time, money, people and technology to make sure that we've got this right," said Stephen Siderow, president of BlueMountain Capital Management, a hedge-fund manager overseeing investments of $2.7 billion. "We think these kinds of conversations between dealers and regulators can be very valuable."
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