Systemic risk n The TRADE Derivatives forum

Prior to the collapse of Lehman Brothers, there was already regulatory concern on both sides of the Atlantic that innovation was running ahead of existing operational procedures in the OTC derivatives markets. Trade confirmations could wait weeks if not months for completion. As

2007 turned to 2008, concerns about the proper documentation and risk management for OTC derivatives trading gave way to concerns about wider systemic problems in the financial markets.

Just as the Great Depression changed forever the outlook of those that lived

JEFF GOOCH

continued

This is a massive step forward for the industry.

The second change is transparency. In 2008, there were no trade repositories as now defined. Though there was a trade confirmation warehouse operated by The Depository Trust and Clearing Corporation, but regulators had no visibility of which counterparties or instruments were involved with trades. This led to another key concern of the crisis – that participants themselves didn’t know the extent of their counterparty risk and had to assume the worst.

The big change after Lehman Brothers’ collapse was reporting, on a voluntary basis, of all trades by the banks to regulators and that’s now being locked in through the Dodd-Frank Act in the US and the European markets infrastructure regulation in Europe.

The third problem in those
days was that most counter-
parties faced each other in
bilateral trades. That created a
number of interdependencies
that were hard for regulators
to understand and manage.
Additionally, a lot of those
exposures were not collater-
alised, which led to unwieldy,
large exposure. This was the
problem with AIG, which had
massive exposures with banks
that had very infrequent col-
lateral calls.
Today, market participants
are much more focused on
posting collateral daily so the
exposures are not large. Also,
clearing has been mandated
in most markets to stop firms
directly facing each other in the
first place.
Some people debate whether
central clearing makes things
safer or not, and it’s always
a difficult thing to work out.
However, what it does mean is
there’s a lot more transparency
about the relationships and
it’s easier for the regulators to
intervene to try and sort things
out rather than have to deal
with the bilateral issues that
used to exist.” n
“
CHARLES
MARSTON