The credit crisis in 2008 revealed an astonishing concentration of counterparty risk in a few firms. The bankruptcy of one such firm, Lehman Brothers, triggered the near collapse of the financial system.
In the years since, there has been no dearth of intelligent comment. Very little has, however, been written explaining why instruments expressly designed to distribute risk ended up doing the opposite. This article is my bit at remedy.
The concentration of risk is a natural consequence of the way the derivatives – indeed all – markets operate. This natural centrifugal bias was reinforced by the growth of the credit derivative market in the years leading up to 2008.
An important but overlooked aspect of the derivatives market is the search and co-ordination costs of finding the opposite side of the trade. Search costs can be prohibitive. Firms called market makers lower these costs by standing in between prospective buyers and sellers. They quote a two-way price at which users can buy or sell. For example, a firm keen on selling a future position on a commodity need not look for a buyer. It can just sell the position to a market maker. The market maker will find a suitable buyer to offload the position.
Every such transaction (foreign exchange, rates, commodities, credit) exposes the market maker to two risks — market risk and credit risk. A market risk is the risk of an adverse move in the price of the commodity between the time it was bought and sold. A credit risk is the risk of the client not performing on its derivative obligations. Managing these risks efficiently is the business of market making.
Market risks are hedged by entering into the opposite trade in the market. There are very strong increasing returns to scale in hedging a market risk. A market maker with a strong franchise of buyers and sellers is assured of the opposite side of the trade, either in existing inventory or in future orders from customers. This assurance lowers its cost. In turn, it allows the market maker to offer tighter spreads and attract ever more business. No wonder a handful of firms were counterparties to a large percentage of derivative transactions.
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At least till credit derivatives came along, there were no similar advantages to scale in accumulating credit risks. Credit risks were hard to trade. They piled up on the market makers’ balance sheets, requiring expensive capital to cover for possible losses. This was the single biggest check on the expansion of the market-making business.
The illiquidity of credit risk was especially restrictive for market makers. In the US, market makers were usually arms of investment banks. For a set of historical reasons (Glass-Steagal Act), American investment banks had limited institutional capacity to evaluate credit risk. Major European players like Deutsche Bank and Barclays did. But they were limited by the geographical reach of their commercial banks.
Enter credit derivatives. Credit derivatives created a market for the probability of default. Credit risk – the probability that a firm will default on its obligations – could now be bought and sold. The increased negotiability of credit risk unshackled market makers from their institutional limitations. The risk of a derivative could be cleaved into its constituent elements: market risk hedged; credit risk sold down to local banks and global investors, hungry for credit exposure.
There were advantages to this new way of doing business. Market makers could serve customers whose credit risk they were not comfortable with. They could operate globally. The economies of scale allowed large market makers to offer the latest risk-management products at competitive prices to an entirely new client universe.
But there were disadvantages. We now know that the financial system was hostage to the solvency of a handful of market-making firms. These firms were too interconnected to fail. The many failings of the management of these firms have been richly told. Less has been written about the structural temptation these market makers face.
Market makers are at the crossroads of a lot of information flow. Their traders have rich insights into who is buying, who is selling and in what quantities. With such insight comes the temptation to monetise that information by placing proprietary bets in the market. In a low-volatility environment, placing such bets is, in the narrow sense of the world, rational. It takes an exceptionally long-term greedy sort not to give in to such rational temptation.
I don’t claim that the credit crisis was inevitable. Like any such event, it was the result of a complex interplay of a number of factors. However, as we think about the regulation of the derivatives market, it may be useful to keep in mind that the structural factors contributed to the crisis. To paraphrase Oscar Wilde, the credit crisis was either an unfortunate accident or an unpleasant result of temperament. Or both.