The third anniversary of the Lehman debacle continues to weigh heavily on the tag team of Merkel and Sarkozy as they try to block a Greek tragedy titled, ‘Contagion’ from closing the curtain on the Euro.
Amidst that country’s ever-growing sovereign debt crisis surfaced a now-familiar character in our global financial thriller-cum horror story—derivatives. Remember them, the ones Warren Buffett so famously derided as financial weapons of mass destruction?
While regulators on both sides of the Atlantic got a handle on who held Greek bonds, they also scrambled to figure out who was on the receiving end of some $80 billion of derivatives insuring those same bonds. Concern was rightfully focused on whether any of that default risk was concentrated with weak financial players, which could ignite a replay of 2008’s viral market contagion.
Joe Public, me included, assumed that the opaqueness of this market would have been dealt with by now. Not so fast, say the financial lobbyists who have stalled implementation of the Dodd-Frank regulatory framework.
By recent counts, it’s business as usual. The Bank for International Settlements (BIS) reportsa $601 trillion global tally as of YE 2010, up from $586 trillion in 2007, at the outset of the global economic crisis. This is almost ten times the size of global GDP, indicating that the market continues to be dominated by massive stacks of ‘naked’ bets on a smaller underlying asset base. Banks writing these bets argue they provide a valuable risk management tool for the market, while conveniently, also lining their income statements with much-needed fee income. Remuneration aside, most will accept that this market has come to be the most efficient transportation system to distribute risk ever created by man. Think of it as an autobahn of risk, with seat-belts at drivers' discretion.
And on this risk autobahn, what would normally be a small risk event, say a single borrower default (Lehman, for example), can have an impact across a much larger swath of the market. As 2008 showed us, a single collision can quickly turn into a life-threatening, multi-car pile-up on our risk autobahn. This explains why regulators want to install traffic lights and enforce seat-belts; i.e. push the derivatives business onto ‘well-lit’ centralized exchanges and require more collateral on trades.