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Tetsuya Ishikawa: Derivatives are widely blamed for the credit crunch, but a US proposal to shut down the market is misguided

Guardian Economics 1st February 2009

Many have blamed credit default swaps (CDS) for being at the heart of the credit crunch and, to that end, the US has already seen the first piece of draft legislation looking to rein in this market. While this rightly brings to the fore the debate about how the CDS market should be regulated, it fails to resolve the real issues at hand.

Credit default swaps are insurance contracts on credit assets, such as bonds or loans. For a pre-determined number of years, an investor can buy "protection" for an annual fee. If the asset defaults during that period, the "protection" seller reimburses the "protection" buyer with the loss he's incurred.

When the first CDS was created by a group of JP Morgan bankers in 1997, the intention was to remove the credit risk from a balance sheet without touching the actual asset. What made it easy to do was that this derivative, so-called because it derived its outcome from an asset outside the trade, involved only two parties – the "protection" seller and buyer – dealing directly with each other. But given this "over-the-counter" nature, the market naturally grew as more market participants started to trade these CDS contracts outright.

Today, it is a $57tn market but the growth was largely due to the ability to trade CDS contracts without actually owning the underlying asset they were "protecting". It is this point that the draft legislation tackles by allowing investors to buy protection only on credit assets they actually own. This would undoubtedly kill the market, something that not just bankers but academics and regulators themselves object to.

Even Warren Buffett, who once referred to derivatives as "financial weapons of mass destruction" in a 2003 letter to shareholders, has been an active user of derivatives. According to his Q3 2008 earnings statement, he reported losses in excess of $2bn seemingly on CDS contracts referencing the riskiest tranches of a CDO. And his $5bn investment in Goldman Sachs, one of the world's leading derivatives firms, would seem even more counter-intuitive.

But his letter shows that he foresaw the fundamental problem with derivatives, which ultimately exacerbated the severity of the credit crunch. Over-the-counter derivative contracts are only effective for so long as the two parties themselves are operational. This counterparty risk hasn't been ignored altogether. In a parallel to regulatory capital for banks, all these trades require the parties to post some cash as collateral in case they cease operating.

Buffett argued that unless these contracts were fully collateralised, the ultimate value of these derivatives depended on the creditworthiness of the parties involved. The worse the creditworthiness, the lower the value of the derivative. Not only does this explain the enormous loss in value we have seen in derivative contracts today but it also shows how a vicious cycle has formed. Losses all around lead to a deterioration in creditworthiness for everyone, which leads to a further devaluation of derivatives contracts and more losses.

This draft legislation fails to tackle this critical point. It may kill the market in the US, but the rest of the global market would continue to operate, pushing market participants abroad and making this legislation redundant. Moreover, the problem isn't just credit derivatives but all derivatives. A failure to acknowledge this will only misguide the world into a false sense of security.

Fortunately, there have been calls made by regulators such as Charlie McCreevy, the EU financial services commissioner at Davos and academics such as those that faced the Treasury select committee earlier this year, which tackle the real issues of systemic risk that Buffett highlighted back in 2003.

The essence of the alternative is to have better regulation and oversight of these "over-the-counter" derivatives by creating a central clearing house, acting as a central counterparty to all market participants. This not only removes the counterparty risk between the two parties of a derivative trade, but it would allow regulators to assess very quickly the net market exposure and risk that each and every institution holds through derivative contracts. Some would go further by arguing all derivatives should be traded on exchanges, like the main equity cash and futures markets, which would bring further transparency, clarity and oversight.

Calls to bring an end to the derivatives markets, though, are premature. Ultimately, derivatives provide a useful means by which market participants can transfer risk to those who are better able to hold that risk on a micro level. It's the systemic risk that needs to be tackled.

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