Peter and Henry what I worry about with derivatives is the collapse of one "leg" of the trade: ie. the often dreaded, often forgotten "the Herstatt effect".
Now, both of you at once. "What in hell is the Herstatt effect?"
...listen for a moment to the echos.
"Friend, do you never stop top ask yourself
If Lovers heed what you say?
YOU think they hear your words? Let me tell you
They and their thoughts are miles and miles away."
Mir, Mughal Poet, the mid-18th century, India
For Private Use Only
Derivatives loom as greatest hidden evil
There's a monster out there
By Paul E. Erdman, CBS MarketWatch
Last Update: 12:25 PM ET Aug 28, 1998 See StockWatch
SAN FRANCISCO (CBS.MW) -- In the face of what may become the most severe global financial crisis since World War II, so far the world's key financial institutions have been able to cope rather well. To be sure, some, like Credit Suisse, have taken big-time haircuts, but nothing that would threaten their survival.
So far only the first shoe has dropped, involving, for example, writedowns of bad loans to Russia and of Russian notes and bonds. If the situations in Eastern Europe and Latin America deteriorate further, more writeoffs of this type will gradually become necessary. But the nature and size of these risks are generally known, and are deemed manageable.
However, there is a related type of bank exposure that is essentially invisible. It is off the balance sheet, and basically uncontrolled. I'm talking about derivatives, especially hedges in the form of forward foreign exchange contracts and interest rate swaps.
Such exposure in Russia alone is more or less "known" to be in the $65 billion range.. What is unknown is who is at the end of the daisy chain where such transactions are concerned. If too many end up at the same institution, the question then is whether that institution will be able to cough up when these contracts come due.
And if not, then what?
We found out way back in 1974. The bank involved was Bank Herstatt of Cologne, Germany. It had to close its doors because it was on the wrong side of too many forward foreign exchange contracts that had suddenly come home to roost. Its closure took place after the settlement of the deutsche mark leg of foreign exchange transactions, but before settlement of the dollar leg.
In other words, American banks doing business with Herstatt did not get the dollars they were due after they had already paid the marks they owed the German bank. Some of Herstatt's trading partners, faced with nonpayment, then refused to make payments on their own account or for customers.
The result was a chain reaction that, in essence, froze transfers between banks, and brought the whole global financial system to a halt.
This became known as "the Herstatt Effect."
With today's volume of such transactions immeasurably greater than it was back then, and with currencies under increasing pressure on every continent on earth, one has to wonder whether another Herstatt is lurking out there."
I could go on and quote more Mir from the greatest if not most obscure book of poety ever published but it might just upset you both.
With best wishes -
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