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The Start of Another Financial Crisis

It's a deja-vu: the stability of the global markets could soon be under threat due to a looming crisis in the derivatives industry.

The stability of global markets could be once again threatened by another massive financial derivatives crisis, according to market participants.

Due to a loophole called the “futurization of swaps” as a result of a change in the way derivatives are packaged and sold, traders are bypassing regulations aimed at containing risk and instead, are investing more money in riskier trades.

As a result of the 2008 financial crisis and the ensuing Dodd-Frank regulation, investors are now required to set aside enough capital to cover losses on their derivatives trades.

But traders are now bypassing these margin requirements by repackaging swaps into futures. Futures are less regulated, allowing investors to take larger positions while reserving smaller amounts of cash.

Companies that operate futures exchanges say the shift from swaps to futures is a natural evolution in the marketplace and that futures exchanges have a sound track record of carefully managing risk, the Huffington Post notes.

“When you migrate to futures, you’ll be able to get much better margin utilization and therefore put up less capital,” Larry Tabb, CEO and founder of TABB Group said in a HuffPost Live panel, entitled “Another Banking Crisis?”

Underlying the risk of another major financial crisis, James Cawley, CEO of Javelin Capital Markets, noted that since futures have one fifth of the margin requirements of a swap and are therefore measured on a more advantageous risk basis for clearing houses, exchanges who haven’t properly accounted for risk could be at risk of failure, leading to a major systemic issue.

“It’s like AIG, who failed to account for the right margins in that context,” Cawley said on the HuffPost Live webcast. “You could see the same thing with clearing houses as they attempt to do the same thing for their own gain.”

From a policy standpoint, if you have private institutions that have shareholders and have to generate dividends while also having the possibility of benefiting from a government bailout in the future, there is an internal tension that will always exist, he noted.

In that case, there is little incentive for clearing houses to really try to avoid a bailout, panelists said.

“Risk needs to be appropriately managed, whether it’s a swaps contract or a futures contract in a clearing house,”Cawley warned.

A survey by Swiss bank UBS of firms in the $639 trillion swaps market found that traders expected they would eventually replace 20 to 25 percent of their swaps portfolios with futures, the Huffington Post reported.

Melanie Rodier has worked as a print and broadcast journalist for over 10 years, covering business and finance, general news, and film trade news. Prior to joining Wall Street & Technology in April 2007, Melanie lived in Paris, where she worked for the International Herald ... View Full Bio

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ischmerken
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ischmerken,
User Rank: Apprentice
2/26/2013 | 3:28:28 PM
re: The Start of Another Financial Crisis
The "futurization of swaps" has the potential to derail the swap execution facilities (SEFs) which were meant to be regulated platforms for OTC derivatives. If exchanges offer more favorable margin treatment for swap futures than SEFs can offer, there is no level playing field or competition as required by Dodd-Frank.
Ivy Schmerken
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Ivy Schmerken,
User Rank: Apprentice
2/26/2013 | 3:28:28 PM
re: The Start of Another Financial Crisis
The "futurization of swaps" has the potential to derail the swap execution facilities (SEFs) which were meant to be regulated platforms for OTC derivatives. If exchanges offer more favorable margin treatment for swap futures than SEFs can offer, there is no level playing field or competition as required by Dodd-Frank.
Melanie Rodier
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Melanie Rodier,
User Rank: Author
2/25/2013 | 12:23:33 PM
re: The Start of Another Financial Crisis
I agree Nate. Unless of course regulators don't act fast enough after hearing the warning bells. Economists had warned about the last financial crisis before it happened, in the same way that people warned the SEC about Madoff's Ponzi scheme, yet they still failed to stop these (and many other) events from causing havoc.
Nathan Golia
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Nathan Golia,
User Rank: Author
2/22/2013 | 6:30:06 PM
re: The Start of Another Financial Crisis
Interesting, but I have a sneaking suspicion the next financial crisis won't be based on a practice that's widely visible in media Gă÷ sort of like the last one.
Greg MacSweeney
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Greg MacSweeney,
User Rank: Apprentice
2/21/2013 | 10:54:20 AM
re: The Start of Another Financial Crisis
You would like to think that exchanges have properly measured risk if they plan on carrying futures contracts. What would happen in this fragmented market if a major exchange collapsed because of miscalculated risk? Is it a case of TBTF? Or will the market participants shift trading to other venues and continue on?
mb
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mb,
User Rank: Apprentice
2/20/2013 | 10:02:56 PM
re: The Start of Another Financial Crisis
futures are mark-to-market and settled daily.
there is no way it is more riskier than totally non-transparent swaps OTC market with its mark-to-model crap
Jonathan_Camhi
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Jonathan_Camhi,
User Rank: Author
2/20/2013 | 9:02:56 PM
re: The Start of Another Financial Crisis
Although derivatives played a big role in the last financial crisis, I read some article recently that made a convincing argument that the real damage from banks was done on the lending and mortgage side. Giving mortgages to people who couldn't afford them and everything. I think a little bit of the pounding that derivatives got from the media after the financial crisis was simply due to the fact that they are complex and people tend to be suspicious of things that they don't understand. That said derivatives did at least make the financial crisis more dangerous and I hope regulators are looking into how they should respond to this growth in futures.
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