The "Smart Money" Stampede

Wall Street Polyannas, smoke-blowing pundits, and ivory-tower academics downplay or dismiss the risks associated with the rapidly-growing credit derivatives market, arguing that sophisticated market participants have a vested interest in working together to avert disaster. Yet according to a recent Bloomberg report, "Trichet Warns of `Dangerous Herding' Derivatives Risk," if and when someone eventually shouts "fire" in the crowded financial theater, cooler heads might not necessarily prevail among the "smart money" crowd.

Credit derivatives may create risks to the financial markets if events prompt investors to exit at the same time, said European Central Bank President Jean-Claude Trichet.

Investors "may react in a way that can suddenly lead to dangerous herding behavior," said Trichet, who was speaking in Boston at the annual meeting of the International Swaps and Derivatives Association, which represents 750 banks and securities firms. "Such situations are also a matter of concern from a systemic liquidity viewpoint."

Credit derivatives are the fastest growing financial market, surpassing bonds and loans as a cheaper way to speculate on credit quality. The market has doubled in size every year since 2003, with outstanding contracts covering $34.5 trillion of securities, ISDA said today.

The decade-old market hasn't been "stress tested" in a crisis, Trichet said. There is potential for "counterparty risk" if investors to seek to exit at the same time, he said.

Potential herd-like behavior could reduce market liquidity and affect the ability of a "significant" market participant to finance its business, Trichet said. Such problems are low- probability events, Trichet added. The consensus view is that derivatives help efficient risk management.

If liquidity were to fall, "potential loss to the financial system" would be "great," Trichet told delegates at ISDA's conference. "The fear is that a large proportion of market participants may have become excessively complacent."

Until, that is, the alarm bells start ringing.

Comments

[stumann]

but what if the credit derivative market really is dominated by central banks, as many conspiracy theorists warn. these markets don't need to be regulated because they are already regulated the old fashioned way - they're rigged. No one writer on the "alt econ" forums said boo about the fake Fed Reserve notes intercepted in Manila a few years back - keeping in mind there is no market for these notes outside of central bank swaps - they're prima facia evidence central banks are conspiring together as the source of over liquidity.

anyone waiting for the big decline or relying on elliot wave forecasting will ultimately be dissappointed - market cycles have ceased to function because those entrusted to regulate markets are now rigging them. ponzi debt creation can continue indefinitly under hot house conditions. the global debt bubble could very well continue to inflate until markets dislocate - meaning, there will be no winners.