Financial Update (October-December 1996)

Are Derivatives Dealers Vulnerable
to Market Meltdown?

Could dealer losses in times of over-the-counter (OTC) derivatives market turbulence lead to serious implications for other participants and the market as a whole? Atlanta Fed economists Larry Wall, Ellis Tallman, and Peter Abken explore this scenario in Working Paper 96-6: "The Impact of a Dealer's Failure on OTC Derivatives Market Liquidity during Volatile Periods."

any policymakers' unease about derivatives markets—which deal in a variety of contracts that depend on other contracts for their value, such as options, futures, interest rate swaps, and currency exchanges—continues as these markets expand. Perhaps the greatest fear is that a disaster will occur in derivatives markets, with catastrophic consequences for the economy.

Little concern seems to exist regarding the U.S. derivatives exchanges, such as the Chicago Mercantile Exchange. These exchanges have been operating in their current form for decades and have demonstrated the ability to operate in adverse market conditions. The likelihood that an organized exchange would pose a systemic risk is small. However, many important OTC markets, such as those for interest rate and currency swaps, did not exist prior to 1980 and have sustained very high growth rates over the intervening period. The ability of these markets to operate in difficult periods, without experiencing systemic problems, has not yet been adequately demonstrated.

In the absence of experience in the OTC market, a number of observers have speculated on various scenarios in which OTC derivatives could have macroeconomic consequences. Unfortunately, evaluating the internal consistency, probability of occurrence, and likely losses should such systemic events occur is difficult. The scenario that has received the most attention is as follows:

  • credit losses to derivatives customers cause one or more dealers to fail;
  • the failure of the dealer in turn causes losses at other dealers, which cause additional failures; and
  • each wave of dealer failures causes additional credit losses, which generate more waves.
Most studies indicate that the odds of such an eventuality are small because each dealer's exposure to credit losses from individual counterparties is a relatively small fraction of its capital. However, these Atlanta Fed researchers consider another scenario.

Suppose that a dealer fails during a period when market prices are volatile. Even if the dealer's counterparties do not suffer any credit losses, their derivative contracts have nevertheless been terminated. Given that market prices are volatile, the counterparties will need to arrange replacement derivatives immediately to hedge their pre-existing exposures. Well-known, highly rated firms may be able to arrange hedging instruments with relatively few problems. However, less well known and lower-rated firms may have substantial problems arranging replacements.

Banks could have a legitimate concern in a situation where weak dealer firms may enter the market seeking to arrange speculative contracts in a "heads I win, tails the bank loses" sort of speculative deal. Given some time, the banks would be able to separate the firms seeking replacement hedges from the would-be speculators. However, given that the hedgers need to find replacement contracts quickly, the banks could be faced with a choice of accepting all of the not so well known firms or rejecting all of them collectively. The working paper focuses on the potential credit losses to a bank and the prices a bank would need to charge to cover its expected losses.

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