Minyan Mailbag: Derivative Risk
I'm not holding my breath for an independent re-marking to value of OTC derivative contracts.
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The one angle that I wanted to raise with you - and I don't think that this has yet been explicitly identified amongst other risk factors in the derivatives markets (per the NYT article) - are the operational risks. I worked in derivatives trading (commodities and fixed income) at a large Wall Street bank for over 10 years. I have two observations from this experience:
1) The quality of the people matter because (as you well know) risk management is as much an art as a science. Experience and judgment thus matter. Lower the caliber of your team on any of these two metrics and you increase your risk.
2) (and this relates to (1) above) The operational infrastructure, which collects, packages and then reports the risks to risk managers and management, are very frail in a lot of these institutions (and thus raises the importance of good people).
My conclusion from the above is that it could be as much an operational error (unbooked trade, incorrectly booked trade, etc.) that serves as the trigger to a larger event as anything else. The derivatives systems at big banks have improved dramatically over the last decade but at some places they have lagged the market/product evolution dramatically. Layer on top of this the integrational issues with acquisitive big banks and one should be very wary of operational risks. This is especially true when upper management is not derivatives literate. I think we got a taste of this last week with the (I believe uncorroborated) Reuters story about problems with JPM's MSFT trade. The whole credit derivatives settlement issue is another potential pothole; at a minimum, the Corrigan report seems to have focused some attention on it.
Thanks for your thoughts. They are great points from someone who has been there and need no additional comment.
However, I just want to reiterate one related point that I have made previously, that the price at which OTC derivative contracts (by far larger than listed derivatives) are carried on the books of dealers are determined by traders and are likely very aggressive. A truly independent re-marking to value might cause some pretty stiff write-offs at these behemoth dealers.
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