The future of derivatives

Derivatives have often been held responsible for various market breakdowns in the past. The sub prime crisis is no exception. At the heart of the current financial crisis have been OTC derivatives, especially Credit Default Swaps (CDS). The CDS market had grown to $62 trillion in notional value by early 2008. To put this figure in perspective, the size of the global economy in 2008 was approximately $55 trillion! It is because of the huge volumes of CDS transactions that insurance giant AIG had entered into, that the US Treasury had no option but to intervene and bail out the insurance giant. If AIG had collapsed resulting in the dishonor of many CDS contracts, these would have been mayhem all around. Similarly Bear Stearns was so deeply entangled in the CDS market that regulators feared its collapse would lead to chaos. That is why it was bailed out in early 2008.

It is because of such concerns that regulators and the industry body, International Swaps and Derivatives Association (ISDA) have had to intervene. And there are some indications that the CDS market has started to cool down. After growing 100 fold from the middle of 2001 to the end of 2007, to a value of $62 trillion, in the first half of 2008, the value of outstanding CDS positions has declined significantly. The decline has been facilitated by netting out trades that offset each other. The next step being discussed is central clearing of OTC trades.

Despite the problems arising out of the indiscriminate use of CDS, one can hardly imagine a world without derivatives. Just because a few players used derivatives indiscriminately is hardly a reason for banning the use of derivatives. Instead what we need are better mechanisms for reducing counterparty and settlement risk. To address the current concerns in the CDS market, some 17 large dealers have come together to launch a clearing house for credit derivatives. A central counterparty backed by a default fund would greatly reduce the probability of the system becoming unstable due to any one player’s failure. Exchange based arrangements may also over time deal with other challenges such as a more precise definition of credit events. More recently, the US Treasury has come out with new guidelines that would call for better disclosure of derivative trades and capital backing and a shift from OTC trades to exchange trades wherever possible.