But it’s one that has gained colour from the debate about derivatives. An oddly polarised debate. Overstating it somewhat: in one corner, a group contending that derivatives bring tangible benefits to civilisation. In the other, a group arguing that they have within them the seeds of severe disorder. Unsurprisingly, my take is that the truth lies somewhere in between. It is nicely illustrated by the quite extraordinary development of the credit derivatives market over the past five years or so.2  Dispersion of risk, and the price of risk Credit derivatives plainly have been used as an effective risk management tool by a number of banks and others. Contrary to some suggestions, the acid test is not especially whether banks, individually or in aggregate, have been net sellers of credit risk. Individual banks have been able to reduce concentrated loan exposures to single corporates, industries or countries. As the Telecom episode reminded everyone just a few years ago, that is really important, if elementary. Individual banks have also been able to increase their exposure to borrowers with which they do not have a lending relationship. (Indeed, some commentators suggest that it may sometimes be more effective for second-tier and smaller banks to take corporate credit exposure via the derivatives market than via participation in the lower tiers of loan syndicates.)
If short-term traders are structurally long, their dynamic hedging may have the effect of dampening market movements, producing zones of local stability. But where, as a group, they are structurally short, their dynamic hedging can sometimes amplify price movements, increasing volatility, if the market proves illiquid under stress. While I have set this out in a rather general way, it isn’t fanciful. There are examples of it going back over nearly twenty years: some involving the explicit writing of options; some implicit writing of options; and some arising from trading strategies that mimic optionality. For example, the 1987 equity market crash was exacerbated by the prevalence of portfolio insurance, a trading strategy akin to delta hedging an option: sell when prices are falling. A dynamic variant of a ‘stop loss’. Similar strategies are now a key feature of some Principal-Protected hedge fund investments, via so-called Constant Proportion Portfolio Insurance (CPPI). To preserve the nominal principal, the ‘guarantor’ will sell units in, say, a fund of funds as its value falls, and vice versa. I guess some assumptions are made about underlying liquidity, and that these are reflected in how such strategies are effected. 2  BIS Review 50/2005  In 1994, and again in 2003, hedging the negative convexity of US mortgage-backed securities amplified the rise in dollar bond yields, with some violence.3 The underlying factors here, of course, are that US mortgage borrowers have an option to prepay, so they are long options on mortgage interest rates.