When President Obama signed the financial reform bill in July, it marked the end of one of Congress' longest-running dramas. Both the public at large and financial services companies in particular had watched the drama unfold with a combination of fascination and trepidation.

Now, as banks and Wall Street try to find their way through this new and potentially dangerous forest, they will need the financial equivalent of a GPS, and some experienced guides.

One area of uncertainty is the hotly debated but poorly understood issue of the role of derivatives in the markets, both before and after the meltdown, and the role of dealers in the derivatives market.

If we are going to distinguish between landmarks and mirages, we need to understand something about what derivatives are, how they work, and where their dangers lie. The first step is to distinguish between derivative securities, like mortgage-backed securities, collateralized loan obligations, and collateralized debt obligations (the villain of the play), and derivative instruments, like interest rate swaps, currency swaps, and credit default swaps (the monster in the closet).

The debate on derivatives didn't necessarily distinguish between these two classes, but we must, if we are going to make sense of the landscape. Derivative securities, like other securities, are issued, bought and sold, and represent assets to the owner. They have market values and trading volumes and, when the trade settles the counterparty risk goes away. Derivative instruments, on the other hand, are bilateral agreements about cash flows, so they aren't issued, bought or sold, and don't represent assets to either party. They don't have market values, at least in the same way as securities, the trading volumes don't work the same way, and once the agreement has been signed the counterparty risk begins, not ends.

Confusing these two instrument classes, while a common error, has far-reaching regulatory implications.

One area of confusion relates to the volume of derivative instruments outstanding, and the risk such volume entails for market participants. Given that these instruments aren't usually bought or sold, when one party no longer wants to be bound by the agreement it isn't a simple matter of selling out, as it would be with a security. Instead, the most common transaction is not to sell the position but to enter into the same agreement on the opposite side. So a significant fraction of the total outstanding positions in derivative instruments are actually back-to-back arrangements.

A historical example of this phenomenon is what happened when Lehman Brothers went bankrupt. At that point there were Lehman CDSs in force with a notional value of $600 billion. After market participants netted out the back-to-back positions, the remaining notional amount was about $6 billion. That's not a tiny number, of course, but it is only 1% of the gross amount.

So the risk in the market relative to the reference entities (the party whose default is being insured) may be much lower than the raw numbers suggest. But the risk relative to the counterparties (those selling the "insurance" and receiving the "premium") may be much larger than is generally known.

The first thing to note is that the original issuance of CDSs tends to be concentrated in a small number of banks and insurance companies. The second thing is that, because so many of the CDSs are laid off in back-to-back arrangements, the total exposure of original issuers may be masked in the larger volume numbers. However, if you were to trace most of the CDSs in existence through all the back-to-back arrangements, you would arrive at the same banks and insurance companies most of the time. Except that neither you nor the regulators can trace back, because these are private, bilateral transactions. This issue is the reason for the Dodd-Frank mandate to trade and carry positions on swap execution facilities.

As logical as this might seem, the big swap dealers fought this provision because they felt it would commoditize the products and reduce their profit margins, and they gained a partial victory in restricting the SEF requirement to "standardized" products. There may be some room for clarification on the term "standardized," but most market participants agree that a typical fixed-floating rate swap would be a standard contract, as well as a CDS on one of the widely quoted indexes maintained by Markit.

For derivatives customers, this poses an interesting dilemma: do they use standardized derivatives to hedge or speculate — balancing the possible basis risk against the more efficient pricing? Or do they opt for customized derivatives and accept the wider margins in order to get better tracking? For CDSs, there is a particular "basis risk" inherent in using a standard security or index to hedge a particular holding, since the payoff of a CDS is related exactly to the reference entity, not to general markets or market sectors.

Whichever choice they make, non-dealer derivatives users will have to employ more (and more sophisticated) analytics in choosing and monitoring the derivatives they use. In the same way that non-dealers found that they couldn't rely blindly on dealer research on equities, or fixed income, or foreign exchange, they now see that they must have a level of expertise equivalent to the dealers' in derivatives. This is one forest you don't want to get lost in.

In addition, the highly interconnected nature of the derivatives market means that knowing whom you have done business with is no longer sufficient — now you have to know whom your counterparty has done business with, and whom that firm has done business with, back to the original issuer. If any of the links in that chain break, the result could be catastrophic … or minor, depending on who the weak link is and how big their exposure is.

In other words, market participants must monitor as much exposure information as they can, not only on their own counterparties but on everyone in the market. The sources of this information are currently disparate and sometimes hidden, but difficulty in obtaining or processing this information won't be a valid excuse the next time we have a meltdown. So the rule of managing risk is assessing everyone in the market as if they were a counterparty.

The passage of landmark legislation sometimes clears the fog and lets us see the terrain more clearly. In this case, it probably obscured the way forward instead. Financial market participants now have two choices. They can sit back and wait for the regulators to fill in the blanks, which may be a long time coming. Or they can use their best judgment to move forward with policy and technology choices.

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