WASHINGTON -- The International Monetary Fund warned of systemic risks from the rapidly growing derivatives market, but didn't make any specific recommendations.
In a report on systemic risks in international finance, the IMF pointed to the tendency for derivative products to create arbitrage opportunities and strengthen links between markets, which increases the possibility that disruptions or increased uncertainty in these markets might spill over into other derivatives markets and into the cash market more readily than before.
Crash of 87 Cited
It specifically cited the global stock market crash of 1987, the collapse of Drexel Burnham Lambert in 1990 and the crisis within Europe's exchange rate mechanism in 1992.
The market for derivatives contracts swelled to a nominal $8 trillion by the-end-of 1991, from just over a combined $1 trillion five years earlier. This include interest rate swaps, currency and cross-currency interest rate swaps, as well as currency futures and options.
The sharpest growth has been in over-the-counter contracts, it noted.
"Experience suggests that rapid expansion of, and concentration in, a particular banking activity often signals both a weakening of internal controls and an underassessment of credit risk," the IMF wrote.
Lack of Understanding
The IMF highlighted concerns--that the speed in which the markets for derivatives has expanded and the complexity of many of those instruments have weakened risk management. Senior bank managers and regulators admit to not fully understanding the instruments.
"Participation in derivatives can cause firms to become connected through complicated transactions in ways that are not easily understood making the evaluation of counterparty extremely difficult," the IMF added.
The IMF indicated that it doesn't believe risks could be reduced by channeling more OTC business to organized exchanges. Margin requirements and loss-sharing arrangements have helped cut credit risk on the exchanges.
Since banks support clearing houses and exchange members with lines of credit, the ultimate protection from liquidity risk is the same in both markets, it said.