Proponents argue that the benefits of derivatives far outweigh the dangers. In particular, these synthetic securities allow risks to be transferred from those who don't want them to those who do. In their view, such activity makes the financial system healthier and more resistant to shocks.
However, this perspective fails to take account of at least some current realities. Turnover and open interest outstanding have expanded at a mind-boggling rate, making it difficult for anyone, let alone regulators and policymakers, to gain a solid handle on what is going on. Moreover, much of the activity is centered in lightly regulated over-the-counter markets, and increasingly involves instruments that are breath-taking in their complexity.
In Threats Lurking Behind the Growth of Complex Finance, FT Alphaville (the Financial Times-affiliated blog) notes that
the value of derivatives in the the financial system now totals an astonishing 802 per cent of the world’s GDP, providing 75 per cent of global liquidity. Securitised debt is worth 142 per cent of global GDP, providing 13 per cent of liquidity.
What threat does the rapid growth of these sectors, which now dwarf traditional measures of liquidity such as cash and bank reserves, or broad money including deposits and loans, pose to the financial system, asks Gillian Tett in Monday’s Comment & Analysis?
For Northern Rock [a U.K. building society, or savings institution], the issuer of mortgage-backed bonds which are in turn used to create CDO instruments, the group may be making itself less vulnerable to future economic shocks by moving some of the risk of default into the hands of new investors. That risk sharing also allows it to make more loans. But transferring risk can introduce an element of “moral hazard” into credit lending - where if lenders think they are insured against the risk of default they could be tempted to lend too much.
The transfer of risk also introduces opacity - making it fiendishly difficult to see who might be left holding losses if a credit shock did occur or to prevent concentrations of credit risk developing in the system.
Paul Tucker, head of markets at the Bank of England, conceded in a speech last month that the Bank found it hard to interpret M4 - one of the broadest measures of money - because structured finance and hedge fund activity seemed to be distorting the data. Worse, banks’ balance sheets are no longer an accurate guide to activity either because banks are shuffling risk around. So what would happen in a financial crisis remains - as he put it - “unknowable”.
Right now there is little sign of an end to the credit party, nor it would seem to the mounting uncertainty about what might happen when the debt dance ends.
Last week, the Financial Times also highlighted the Challenge to Central Banks from Structured Finance Explosion.
People who watch financial markets for a living tend to become blase about big numbers. Nevertheless, the latest activity in the collateralised debt obligation (CDO) world, could make anybody blink.
According to data released by JPMorgan this week, total issuance of CDOs - repackaged portfolios of debt securities or debt derivatives - reached $503bn worldwide last year, 64 per cent up from the year before. Impressive stuff for an asset class that barely existed a decade ago.
But that understates the growth. For JPMorgan's figures do not include all the private CDO deals that bankers are apparently engaged in too. Meanwhile, if you chuck index derivative portfolio numbers into the mix, the zeros get bigger: extrapolating from trends in the first nine months of last year, total CDO issuance was probably around $2,800bn last year, a threefold increase over 2005.
Getting a handle on precisely just how far structured finance really is distorting the credit cycle, is - of course - fiendishly hard. For as Richard Portes, a professor at London Business School, points out, there has been little research done on how structured credit is affecting price signals and the allocation of risk through the financial system...
According to Portes,
the structured credit and derivative revolution - all those CDOs - is now creating a new source of liquidity. Economic theory suggests that the pricing of these instruments should still be linked to traditional definitions of money - what central banks control. However, Roche argues that is not always the case. And some recent market behaviour might bear this out: just look at how credit default swaps have moved in the opposite direction of cash rates, partly because of voracious demand from bankers creating CDOs.
Roche's conclusion is that this essentially leaves central bankers increasingly powerless to control liquidity - meaning that not only are they unable to prick the current credit bubble, but will be equally impotent to combat its future collapse.
So, due to the explosive growth of the derivatives market, certain risks are now unknowable or uncontrollable. That doesn't exactly sound like a benefit to me.
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