Derivatives Bring Drama to Davos...

Derivatives bring drama to Davos
By Gillian Tett

Published: February 1 2007 02:00 | Last updated: February 1 2007 02:00

As Stephen Roach, chief economist at Morgan Stan-ley, moved around the debates on the world economy in Davos last week, he admitted that some of the discussions were distinctly bland. With the world economy growing steadily, de-bates about big economic themes lacked real drama.

However, in one area there was a raging debate: the role that the fast-growing derivatives sector may, or may not, be playing in distorting the cost of credit.

"We have just had a pretty lively discussion," Mr Roach said at a lunch to examine derivatives, attended by senior policy officials, economists and financiers. "In fact, this has probably been the fiercest argument I have had in Davos."

A cynic may suggest this reflects the fact that the global economy is so benign that policymakers now have the "luxury" of worrying about financial markets and esoteric instruments, as John Lipsky, the first managing director of the Internal Monetary Fund, put it.

Nevertheless, the focus on structured products does mark something of a departure for the Davos group, given that these issues have generally been ignored in previous years. The public and private meetings re-vealed sharp disagreement about three key points.

The first is whether regulators needed to worry about the fact that the structured finance and derivatives world is often opaque, particularly given the dominant role of unregulated hedge funds.

Optimists say this lack of transparency need not matter, since counterparties handling derivatives - such as investment banks - have a high incentive to monitor risks.

After all, as Andrew Crockett, now president of JPMorgan International and former head of the Bank for International Settlements, pointed out, investment banks do not want to suffer devastating losses.

However, pessimists poin-ted out that these banks were competing with one another to win business. Consequently, some banks "could be facing pressure to let their standards slip", as one regulator said.

Worse, the competitive climate may mean that banks lack the tools and the time correctly to monitor hedge funds - particularly since the instruments these funds are using can be opaque. That "makes it hard to see how much leverage is in the system", one policymaker said.

A second point of debate concerned the degree to which new products are dispersing risk across the financial system. In theory, senior officials pointed out, the proliferation of structured products should mean that credit risks were spread across a host of investors. Since this enabled investors to diversify their own risks, credit shocks could be absorbed easily.

But some policymakers suspect that banks might be re-acquiring risk via the back door because their investment arms are buying repackaged risk products or lending to hedge funds. "Banks have offloaded so many of their risks through hedge funds," said Michael Klein, co-head of investment banking at Citigroup. "But hedge funds have given some of this risk back."

While risk dispersal has helped the system weather shocks so far this decade, some policymakers fear that if a really big crisis were to hit, this dispersal might create a "contagion" effect. That could make a crisis worse, one regulator said.

But the third, related issue was how regulators should respond. Some observers said that policymakers needed to impose more oversight on hedge funds, private equity groups and over-the-counter markets. But others argued that this would be undesirable and impractical.

Meanwhile, the issue of legal authority poses a dilemma, as Stanley Fischer, governor of Israel's central bank, noted. For while banks such as the US Federal Reserve managed to quell the crisis at Long Term Capital Management in 1998, markets are now so international in scale that they cannot easily be controlled by any single authority. That made it hard to gather data in the short term but it also made unclear who had res-ponsibility for the system in a crisis, Mr Fischer said.

Policymakers are trying to deal with this in the Financial Stability Forum, a committee attached to the BIS.

"Every second month we meet in Basel and that is something which creates comfort for us," Jean- Claude Trichet, head of the European Central Bank, said.

One key point on which there was consensus was that more needed to be done.

Howard Davies, former head of the Financial Services Authority and now an academic, said: "We all know that the reality of the financial markets is that risk is being parcelled up and paced around. But international regulatory architecture is still organised as if the world had not changed. As a result, we have a regulatory architecture designed for a bygone age."