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Global derivatives market: a track record of adapting to change


31 March 2009

This is one in a series of articles looking at financial regulation and reform.  

In the call to reform the regulation of the financial institutions that are at the heart of the financial crisis, the role of derivatives contracts as a cause or a significant catalyst, has been unfairly exaggerated.

The current crisis was not caused by derivatives, and will not be solved by any knee-jerk reaction from politicians. Any new regulatory approach to derivatives needs to be more balanced, building on the industry's existing track record in meeting new challenges.

Although derivatives contracts, especially credit derivatives such as credit default swaps (CDS), have played a role in these recent events, they are certainly not the reason behind the crisis and have actually functioned well, and as they had been designed to, even in these periods of extreme stress.

CDS are in essence simple contracts that play an integral part in the credit markets, lowering overall borrowing costs, dispersing risk to those with greater capacity and appetite and providing additional pricing information on the credit of many companies.

Settlement of the contracts after credit events has worked as intended, resulting in much lower net exposures than widely reported and without realisation of the systemic risks that multiple credit events or the failure of a large dealer were supposed to unleash.

Upon the bankruptcy of Lehman Brothers, CDS contracts with a notional value of USD72 billion were settled through an orderly and consensual auction process described below, resulting in net payouts of only USD5.2 billion. 

On the other hand, CDS has contributed to extreme concentrations of risk amongst some market participants, and the resulting exposures have not been prudently monitored.

So what is the proper way to balance the benefits and risks of CDS? 

Certainly, rushed and reactionary efforts to restrict severely the use of the product will not accomplish this. Draft legislation in the United States such as the Derivatives Markets Transparency and Accountability Act of 2009 and the Derivatives Trading Integrity Act of 2009 would respectively require many if not all CDS to be settled through a clearing organisation or traded over an exchange, subjecting them to regulation designed primarily for securities or commodities trading.

This approach is too simplistic and inflexible. Many CDS are not suitable to be traded on an exchange; they are tailored to the parties' specific needs and lack standardisation.

They are also bilateral contracts and do not fit easily into decades old regulatory regimes that are designed for a different purpose.

The Turner Review recognises that the CDS world covers many products of varying complexity and with differing, but legitimate, economic rationale. The regulatory approach should reflect this diversity, and be able to adapt quickly to the innovative and evolving nature of the derivatives markets. 

We must recognise that any solutions must operate on both a domestic and international scale, continuing to strive for a level playing field that allows market participants to build their confidence in each other. Now is not the time for regulatory arbitrage opportunities to emerge, nor for blinkered structures that protect or penalise one sector of the industry more than another.

Also the imposition of new rules, and the additional processes and information that they tend to generate, do not of themselves achieve any benefits. We need the staff at the regulators with the expertise and experience necessary to pinpoint the potential stresses before they become unmanageable, and to implement the appropriate actions or sanctions. This is not a new problem, but it remains key to the success of any new regulatory framework.

The CDS market continues to respond well to new regulatory challenges. For example, in 2005 a number of regulators in the US and EU set the industry formidable targets to improve the infrastructure for settling the terms of unconfirmed CDS transactions.

Since then the number of CDS trades which remain undocumented after 30 days has dropped by 92%, even as the volumes of CDS transactions have increased more than threefold. Huge advances have been made in automating the processes involved and encouraging the use of electronic platforms to achieve even greater accuracy.

A more current example demonstrates the ability of the industry to devise its own innovative solutions, and to achieve extraordinary levels of consensus without the need for externally imposed rules – the CDS auctions. The physical settlement of CDS transactions, by delivery of bonds from one party to the other, risked creating enormous operational and economic problems. 

The solution, devised and tested over a number of credit events (12 in the second half of 2008 alone), was the CDS auction. Parties that opt in agree to a standardised protocol which sets up an auction process to establish a fair market price for the bonds which would otherwise have to be delivered, and then requires net cash settlement of CDS trades at that price.

This solution was entirely voluntary, was not devised or imposed by the regulators, and yet achieved an astonishing level of uniformity across the market and avoided the risks of substantial legal uncertainty and the consequent litigation that might otherwise have arisen.

The CDS auction has been vetted and affirmed this month by the key regulators in the US, UK, Germany and Japan, and will soon be adopted into a huge number of outstanding transactions. No external agency could have imposed such a scheme with this degree of success, consistency and confidence.

So should the industry be left to its own devices? Clearly not. Improved regulation will benefit all the stakeholders – the direct market participants, the end users and the taxpayers who might otherwise have to foot the bill. There is a greater commonality of interest here than is often recognised.

That common interest is best served by measured and informed regulation, and in this the Turner Review seems to be on the right track. What is needed is not a rigid and imposed system, but a collaborative and flexible one which involves both the regulators and the market participants.

The proven track record of the industry in adapting to new challenges should be engaged in this process, not ignored.

Further information

View the webcast: Philip Wood on what really caused the financial crisis and what needs to happen now.


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