When this bomb explodes, the mushroom cloud will be of a magnitude that dwarfs the current crisis and will change the world forever. This bomb is the over-the-counter derivatives market.
OTC derivatives were developed as a legitimate and sensible hedging mechanism against price movements in currency and interest rate markets. From humble beginnings, these derivative contracts, typically made between two counterparties over the telephone, have developed into the most complex financial and legal relationships in existence. And the global OTC derivative market is entirely unregulated. These instruments are not listed on any exchange and their prices cannot be seen in any newspaper. They typically do not appear on any external balance sheet. Should we taxpayers be concerned that governments have agreed to pledge sovereign wealth -- our national inheritance -- to support institutions with black hole exposures that cannot be quantified? Absolutely. Although almost infinite in variety, a common OTC derivative is that known as a credit default swap (often called a CDS).
Bruce has an opportunity to write a huge loan to (or underwrite a huge bond issue by) General Motors. Bruce's credit risk analysts tell him that the loan represents an unacceptable exposure for Bigbank to the car industry -- or perhaps the US economy -- or whatever. This is prudent banking practice. But Bruce needs this deal because, in anticipation of a large bonus in December, he has contracted to buy a chalet in the French Alps and settlement is looming. So Bruce rings Steve within the derivatives team at Bigbank and asks him to arrange a CDS over GM for the new loan. After a few telephone calls to other derivatives teams around the world, Steve has identified that an Australian bank, Ozbank, wants more exposure to the car industry and the US economy. Ozbank's market analysts have determined that its portfolio is underweight in those areas. Under the terms of the CDS, Ozbank will pay Bigbank a margin over the current interbank lending rate every six months and Bigbank will pay Ozbank the interest it receives from GM on the new loan (a little like an insurance premium). Ozbank is delighted because it now has exposure to the US auto industry without having to set aside capital (as it would ordinarily have to do under bank prudential laws) or show the exposure on its balance sheet. (And the rate of interest is outstanding given GM's troubles). Indeed, the clever people at Ozbank have now packaged a few hundred of these contracts within a special purpose vehicle (or SPV), an Ozbank subsidiary, and sold securities in the SPV to a number of other institutions and superannuation funds that would like a piece of the US auto industry.
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