By separating the provision of liquidity from exposure to credit risk, credit derivatives, and the related developments in structured finance, give non-banks new ways of accessing credit risk. As well as more dispersed risk buttressing systemic stability, the innovation of credit derivatives has plausibly taken us a further step towards complete markets, in effect providing a richer market for credit insurance than previously existed. Investors and others may, therefore, be able to get a little closer to the portfolios they really want to hold, which would facilitate a better allocation of risk and so bring broader welfare benefits. This works in the direction of reducing the price of risk, which would reduce the risk premium used to discount uncertain future cash flows. There are, therefore, tangible benefits from the new derivative markets for unbundling and transferring credit risk. And the same can be argued for the earlier development of interest-rate, foreign currency and equity derivatives. So where’s the catch? Short-option positions and market dynamics Everyone is familiar with the risk present in markets if ‘everyone’ tries to sell – or buy – at once. Various features of markets can create the conditions for, or reinforce, such herd-like behaviour. Panic in the presence of excess leverage is the familiar culprit, and goes back to well before the invention of derivatives, as various authors have documented in the context of the Great Crash. Derivatives have not altered the firmament in some deep, unrecognisable way. But they have introduced some novel variations on old themes.
Ex ante, they won’t know for sure which is which. Plausibly, it might not be economical to put controls in place for every single innovation on an assumption of ‘exponential growth’. So when exponential growth occurs, controls can sometimes be left behind. Maybe something like that helps to explain the backlog in credit derivative confirmations, which the FSA cautioned banks about a few months ago. Growth in the market has been relentless. And to the concerns about confirmations have been added concerns, amongst practitioners, about unnotified assignments of credit derivative positions, related in part to the growth of hedge fund participation in the structured credit market. If something really bad were to happen, the system would, perhaps, be less robust than otherwise if dealers were not sure about who their counterparties were, etc. This is the type of challenge where collaboration across the industry is needed; and where individual firms’ incentives are stronger if they can each be confident that their peers are taking broadly the same actions. What I have in mind is the disincentive a firm faces in being tough with a hedge fund client if they doubt their peers will take the same line. Bodies such as ISDA have a role to play here, and I understand are doing so. Collective elements in atomistic markets So, where are the risks? They are all around us all of the time, of course. Some will crystallise. But that need not lead to disorder.