Mayra Rodríguez Valladares is managing principal at MRV Associates, a capital markets and financial regulatory consulting and training firm in New York. She is also a faculty member at Financial Markets World and the New York Institute of Finance.
Despite slow economic growth in the United States and most of Europe still in or hovering around recession, global derivatives markets are 20 percent larger than in 2007. The Bank for International Settlements announced late last week that the global derivatives market is about $710 trillion. That is not a measurement of credit and market risks, but the figure merits attention from regulators and the public, which continues to suffer the ill effects from weakly managed derivatives portfolios in the global financial crisis. Higher volumes are a strong indication that derivatives players’ operational risk is rising.
A derivative, put simply, is a contract between two parties whose value is determined by changes in the value of an underlying asset. Those assets could be bonds, equities, commodities or currencies. The majority of contracts are traded over the counter, where details about pricing, risk measurement and collateral, if any, are not available to the public.
According to the Office of the Comptroller of the Currency, the four largest derivatives participants in the United States are JPMorgan Chase, Citibank, Bank of America and Goldman Sachs, which together represent more than 30 percent of the total global derivatives market. Since the crisis, JPMorgan’s derivatives portfolio has been declining slowly every year and as of the end of 2013 was about $70 trillion. It is still the largest derivatives portfolio in the United States. Bank of America’s portfolio has risen significantly every year since the crisis, mostly because of the enormous portfolio that came with the purchase of Merrill Lynch. Last year, however, was the first time that the bank’s portfolio declined significantly. And its portfolio at the end of the year was $39 trillion.
Goldman Sachs has been increasing its derivatives volumes since the crisis, and it had a portfolio of about $48 trillion at the end of 2013. Bloomberg Businessweek recently reported that as part of its growth strategy, Goldman plans to sell more derivatives to clients. Citibank, too, has been increasing its derivatives portfolio, despite the numerous capital and regulatory challenges, In fact, its portfolio has risen by over 65 percent since the crisis — the most of any of the four banks — to $62 trillion.
Not only is the enormous size of these portfolios of concern, so is the fact that less than 5 percent of the portfolios are regulated and transparent exchange-traded products. The rest is in far more lucrative, opaque over-the-counter products.
And management of derivatives within banks can be as complex and opaque as the products. Big banks have armies of traders, risk modelers, accountants, auditors, operational and technology professionals working on them, and these employees are divided among what are called front, middle and back offices, often in different jurisdictions. Sometimes, banks will outsource some responsibilities for managing derivatives, further raising the bank’s exposure to a type of operational risk known as vendor risk.
And given the skewed bonus system, where auditors, compliance officers, technology personnel and professionals in the back office get paid significantly less than traders and sales people, the very professionals who need to know more about derivatives are often not as well prepared as they should be. Cases like the one involving Barings Bank — which collapsed in 1995, after an employee lost more than $1 billion in speculative investments, primarily in futures contracts — and more recently Société Générale — where a rogue trader lost more than $6 billion on derivatives contracts in 2008 — are important examples of the significant losses that can occur in derivatives portfolios because of poorly trained back office professionals and weak risk management.
Lack of transparency in derivatives markets is not just about how the instruments are priced and how their risks are measured, but also about not being able to see much about where the transactions are recorded. Just because a derivative is bought or sold in New York does not mean that it or its collateral are recorded in New York. Both the derivative and the collateral can be recorded by different entities in different jurisdictions. Because banks can have subsidiaries scattered around the globe, outsiders may not know exactly where derivatives are recorded and whether those entities have good risk management and sufficient liquidity. If a bank in the United States were to fail, its derivatives portfolios would be resolved by the local jurisdiction’s bankruptcy laws, not necessarily United States laws.
The international reach of derivatives portfolios means that different jurisdictions, with their own rules and capital requirements, are supervising the products. In addition, the cross-border reach of bank supervisors like the Federal Reserve and the Office of the Comptroller of the Currency remains unclear in examining subsidiaries and branches abroad belonging to American bank holding companies. Yet what happens with derivatives abroad can come back to haunt the United States.
As regulations like the Dodd-Frank law and the European Markets Infrastructure Regulation start to be take effect, some aspects of the derivatives markets, like pricing and volumes, will slowly become more transparent. What will remain opaque, however, is how banks sell derivatives to clients, in what jurisdictions derivatives are recorded, the strength of risk management and the extent to which governments and taxpayers can be affected if derivatives are again at the center of a crisis.