Warren Buffett famously called them financial weapons of mass destruction. In the world of derivatives, there has probably never been so much devastation as was evident in the aftermath of the collapses of Fannie Mae, Freddie Mac and Lehman Brothers.
The disappearance of one of the most significant players in the derivatives market – Lehman – was never going to be painless. Yet the implications for corporates who had Lehman as a counterparty in their hedges, alongside the chaos in the CDS market triggered by three of the biggest defaults ever, have been felt on a magnitude that, until it occurred, was difficult to envisage.
Derivatives have been eyed with suspicion from the early days of their existence, and not just by Buffett. There has always been a suggestion that if a market crisis were to occur, derivatives would be to blame. It will take time to sift through the wreckage of the credit crisis to fully understand the details of what went wrong, but there is little doubt that credit derivatives have contributed to – and fanned the flames of – the current crisis.
Well before the crisis began there was no shortage of commentators warning about the dispersion of risk throughout the system. On many occasions it has been argued that credit derivatives in particular made problems so highly contagious that any shock in the system would spread like a plague.
The counter-argument was always that a problem shared is a problem halved, and that the more risk was dispersed, the less it would be felt by individual institutions. That argument now looks naïve.
But as tempting as it is to some, it would be grossly unfair to apportion all the blame onto derivatives. To return to Buffett’s metaphor, there is only so much blame you can apportion to a weapon: the person firing it, and those who put it into his hands, must also accept their share.
Although credit derivatives have hogged the limelight in recent months, it is worth remembering there are derivatives contracts based on plenty of other assets and that remain imperative to the smooth functioning of the modern market. With equity markets being pummelled in October, the ability to hedge has been invaluable to many investors and corporates alike. The same goes for commodities, which have for so long looked like a one-way bet, but which have started to look fallible again as fears of a global recession have increased. Although hedgers will be eyeing their counterparty risk nervously, they will certainly be grateful not to be exposed to the vagaries of price volatility at its most violent.
The problem of counterparty exposure has been revealed as one of the main risks within the derivatives industry, but there are already a number of solutions vying for primacy. An increase in exchange-traded instruments will form part of the solution, but perhaps more interesting will be the fate of plans to clear OTC trades through an independent clearing house. The trend has not caught on yet, but prospective providers of this service are in no mood for defeatism, and believe uptake will be better when problems in the markets abate enough for them to give the plan the attention they feel it deserves. Many are predicting that an increase in independently cleared OTC trades will be one of the key themes for 2009.