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The micro origins

By Andrew Sheng (chinadaily.com.cn)
Updated: 2008-11-17 10:27

To assure investors who feared that these assets had no liquidity, the issuing banks gave liquidity "conduits" to these structured products that were contingent buy-back guarantees. All these were conveniently off-balance sheet commitments.

It looked too good to be true, even to the regulators, but they were assured when the market kept on growing. Time and again, Greenspan and others commented on the potential risks, but at the same time remarked that risks were being distributed outside the banking system.

This "black hole" in regulation was in practice the over-the-counter (OTC) market that originated from bilateral transactions between banks and their clients. The largest and most successful OTC market is the foreign exchange market. The advantage of the OTC market is that it is opaque to outsiders, including the regulators, but if the product is well understood, it can be a highly liquid market.

Derivatives in foreign exchange and interest rate derivatives were supported by central banks because it was thought that their evolution would enhance their monetary policy instruments, as well as to enable the banks and their clients to hedge their market risks. That protection was so strong that even when Hong Kong, South Africa, Malaysia and others protested during the Asian financial crises that illiquid foreign exchange markets in emerging markets were often manipulated, these charges were dismissed.

Too much vested interests were at stake. Emerging market supervisors were too weak to change this bastion of non-regulation, because the winners of superior financial innovation were Western banks.

This "originate to distribute" banking model, plus the OTC market, formed what Bill Gross of fund manager Pimco called a "shadow banking" system.

New York Fed President Tim Geithner estimated that this dynamic "shadow banking" system could be as large as $10.5 trillion, comprising $4 trillion assets of the large investment banks, $2.5 trillion in overnight repos, $2.2 trillion for SIVs and another $1.8 trillion in hedge fund assets. This compared with $10 trillion in assets with the conventional US banking system, which meant that system leverage was at least double what was reported.

Throughout the last decade, central bankers would marvel at the phenomenal growth of the financial derivative markets, which conservative fund manager Warren Buffett called "financial weapons of mass destruction".

By December 2007, BIS data showed that the notional value of derivative markets had reached $596 trillion. About two-thirds of this was relatively simple interest-rate derivatives, but nearly $58 trillion was the rapidly growing CDS market. The exchange traded derivatives were $95 trillion in size.

Together, these financial derivatives were 14 times global GDP, whereas conventional financial assets, comprising bonds, equities and bank assets were only 4 times GDP. Market traders reassured everyone that the gross market value of such derivatives were actually much smaller, being $14.5 trillion for the OTC derivatives .

What the traders did not tell you is that although there is some bilateral netting between market participants, the bulk of the transactions remain on a gross basis, since there was no central clearing house to monitor and clear on a net basis, like an equity clearing house. Gross derivatives clearing and settlement (except where bilateral netting apply) could only function if the wholesale market remained highly liquid.

Because these markets are mostly bilateral trades, the OTC market works on a sophisticated and complex system of margin or collateral management. For each derivative trade, the primary dealer calls for margin to protect itself from credit or market risks. In a rising market when risk spreads and volatility are narrowing, less and less margin is required, thus pro-cyclically increasing liquidity. In other words, liqudity begets liquidity, a classic network effect.

Unfortunately, it also works the other way pro-cyclically, so that if volatility increases, the need to call margin, sell assets to realize liquidity would immediately worsen liquidity, widen risk spreads and create solvency problems for the participants.

This was experienced by LTCM in 1998, when it did not have enough liquid assets to meet margin calls. Any stop-loss selling of margin collateral at the highest point of volatility by its counterparties would immediately precipitate insolvency for LTCM.

But this was not immediately transparent to other market players since no single player is fully aware of market positions in an OTC market. There is no single regulator or clearing house to monitor counterparty positions. The opacity of the OTC market is both its strength as well as Achilles' Heel.

The network effects of highly dynamic markets are such that only large financial institutions with specialist skills and computer technology were the winners. The conglomeration of skills, size and liquidity were such that between 2001 and 2007, 15 of the world's largest banks and investment houses (called large complex financial institutions LCFI ) accounted for more than two-thirds of transactions in financial derivatives.

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