Derivatives and Transparency

Counterparty Risk in Financial Transactions

There are a number of risks that exist in financial markets, and one of them is called counterparty risk. Counterparty risk is the risk that one of the parties involved in a financial transaction will not be able to fulfill their obligations and may therefore default.

Counterparty risk is involved every time one party makes an agreement with another party. It is important to be aware of the extent of any counterparty risk that may be present, and while we will never have complete knowledge here, we at least should be operating with a reasonable degree of knowledge.

When we put our money in a bank for instance, we should know a fair deal about how likely it is that we will not lose our money to bank failure. Banking is potentially more risky than people realize, and without modern day oversight, it used to be quite common and easy for banks to go under.

This can not only cause a failure at the level of the bank that we’re dealing with, it can also cause systemic failure, if for instance people lose confidence in banks and look to take too much money out of them generally.

Banks are not set up to bear circumstances like this, as they don’t just keep depositors’ money in a vault, they lend it out and if everyone or too many people want their money, banks simply aren’t going to be able to comply.

This is why we have mechanisms in place where governments step in to provide liquidity to banks, although even this is limited and can only bear so much weight without serious consequences. Since people do have quite a bit of confidence in our banking system, this risk is now low.

Transparency is Required to Manage Counterparty Risk Properly

Banks are under strict reporting requirements to disclose their transactions, providing regulators with enough information to enforce regulations such as capital requirements and look to minimize the risks of bank failure. This is the case with a bank’s normal dealings though, the money they have on deposit as well as the money they lend out, the things that we normally think that banks do.

When it comes to what we could classify as investments with banks and other large financial institutions, the waters are not so clear at all, and the reason why not is that these institutions are heavily involved in certain types of derivatives.

These derivatives tend to be quite complex and the reporting standards as well as the understanding of these financial vehicles is considerably different. We’re not even sure how big the derivatives market is overall, as opposed to the stock or bond market, because we don’t formally measure it, and are left to make educated guesses.

We’re also quite unclear as to what the risk is out there with these derivative contracts, resulting in a situation that presents far more challenges to regulators than with other financial transactions.

This lack is due to the lack of transparency with over the counter derivatives, where parties essentially enter into private contracts to swap risk and cash flow, and some of these contracts can be pretty complex indeed.

Qualitative and Quantitative Regulatory Concerns

The first thing we need when we are looking to regulate something is to know how much there is of something. For whatever reason, over the counter derivatives trading is for the most part not reported like trades on a public exchange are.

These are private contracts though, where for instance one bank may swap interest rates or debt with another. It’s not even so much that we couldn’t delve into the dealings of these institutions and look to compile these transactions, it’s more that we don’t do this.

We could call this the quantitative aspect of derivatives trading, how much an institution is involved in and how much is involved across a sector or in the aggregate. We then would look to assess whether an institution or all institutions are overexposed to the risks of these derivatives.

When it comes to traditional roles of financial institutions, this can be sufficient to give us a good idea of the risks, for instance with a bank lending out too much and needing to maintain a certain amount of capital relative to their lending exposure.

Derivatives regulation is not this simple though. While we can have a pretty good idea of how lending out a certain amount of money may pose risks to an institution, determining their risk relative to their derivative exposure is a different matter and considerably more complex.

We can call this the qualitative aspect of the risk of derivatives, where it is not only how much but how these risks may play out. We need to be aware of both in order to seek to regulate this properly.

Traditional banking is exposed to systemic risks, for instance if we go into a recession, this is going to affect people’s ability to repay their loans. We can account and project for this fairly well, and even though we’re never going to be fully protected and we will see systemic risk rear its head at certain times, we can usually see this coming and adjust somewhat.

Due to the nature of derivatives, the potential impact of systemic risk becomes amplified. A good example of this is seeing how some very big financial institutions such as AIG fell during the recent recession. While many institutions suffered, as we would expect, the concentration of risk at AIG and those who also held a huge amount of risk exposure from derivatives was particularly severe.

We could say that while many did see this recession coming, few imagined the impact that this would have on these large institutions. Bear Stearns had survived and flourished through many recessions, including the stock market crash of 1929 and the Great Depression, but it was no match for the Great Recession, and it was its derivatives exposure that did them in.

While many people speak of improving the reporting of derivatives trading, presuming that this will be enough to get a handle on things and manage these risks properly, what they don’t tend to appreciate is that this is not enough and we also need to be able to assess the risks properly of a given type of swap.

Swaps are not standardized and also tend to be very complex in nature, and without gaining a good understanding of how future events may affect the ability of each party to meet their obligations, just knowing how much there is of this isn’t really enough.

Lack of Transparency Among Institutions

The challenges of managing derivative risk isn’t limited to regulators, as this affects the participants as well, and may affect them a great deal.

When we trade on an exchange, the stock exchange for instance, we can do so with a high degree of confidence that counterparty risk will be reduced to near zero. The primary role of exchanges is to manage this, to ensure that assets are traded in an orderly fashion among market participants and that they will meet their obligations in the trade.

Exchange traded derivatives, like futures, also have this benefit, and when you place a futures trade with your broker, the last thing you worry about is the other side of the trade not coming through, not delivering the contract to you and leaving you paying for the contract but not getting the benefits of it.

If your futures trade makes you money, this is like money in the bank, and you know with a very high level of confidence that your trade will settle each day like it is supposed to. If the value of the contract goes up, money will be taken from the other party and put into your account, and vice versa if the value goes down.

We can say that this type of trading is very transparent, as each side puts up deposits and in a manner that is deemed sufficient. It’s not that there is no counterparty risk in trading futures, but it is kept to a minimum.

When we contrast this with over the counter derivatives trading, things are not so clear on several counts. We are essentially left to hope that the counterparty can fulfill their obligations in the contract, because the amount of risk that they are taking on overall with these contracts is not really that transparent at all.

Transparency is a very important component of an efficient market, because in order to trade in an informed way, we need to have a good understanding of what counterparty risk is present. We may or may not be able to properly assess the other risks in the trade, but we at least have the potential to do so, according to our skill and capacity, and we bear the obligation ourselves to understand and manage these risks.

If we engage in trading where we do not properly understand what our counterparty risk is, we then don’t properly understand the risks overall, which is not a desirable situation to be in for anyone.

Institutions do have a big stake in this and tend to have a better understanding of the counterparty risks than regulators do, not that there really is much in place as far as regulating over the counter derivatives trading anyway. We’re moving toward having more, and some changes have been made over the last few years with the potential for more, but for this is for the most part still a pretty unregulated market.

What happened during the Great Recession is testimony to how big of a gap there can be with institutions, with the best expertise and understanding that money can buy, between what they believe the counterparty risk to be and what it actually turns out to be in certain circumstances.

When risks are not completely known, it is more difficult to price them in, and when they are not really known that well at all, this becomes even more difficult.

The idea behind these trades is to transfer risk from one party to another, but if you’re not quite sure how much risk you are getting transferred, or even how much you are transferring, and especially whether the other party can follow through with their obligations, whether the risk has been priced efficiently or even close to efficiently becomes more of a guess than anything.

In the world of high finance, guessing can come at a price, and a big one. While we may never have a lot of transparency with certain types of complex derivatives contracts, it is necessary that we strive to assess the risks involved as best we can, and that means quite a bit better than we presently manage.