Editorial Board

The New Danger From Derivatives

Don't let a safety mechanism become a threat in itself.

Where it all happens.

Photographer: Daniel Acker / Bloomberg

Global regulators are turning their attention to an important piece of unfinished business: ensuring that a bad bet on derivatives can't upset the entire financial system. They've hit on a good solution -- as long as they can prevent it from becoming a threat in itself.

The 2008 financial crisis proved that derivatives had gotten out of control. Some participants were making huge bets -- say, on the likelihood of bond defaults -- without putting up collateral to guarantee payment if the bets went wrong. When U.S. insurer AIG couldn't make good on almost $50 billion in derivatives-related debts, it nearly brought down several of the world's largest banks.

QuickTake Defusing Derivatives

In response, regulators have turned to a time-honored tool: the clearing house, which stands in the middle of trades and gathers collateral from all its members. The U.S. has already moved most derivatives contracts to central clearing, and Europe is following. Clearing houses will play an increasingly important role in containing systemic risk, setting limits on leverage for banks, hedge funds and other investors.

However, clearing houses present a risk of their own. If a crisis triggers defaults that overwhelm the posted collateral, they have little capital of their own to absorb losses. Beyond that, they'd rely on tapping a pre-paid guaranty fund and then calling in cash from the financial institutions that are their main customers -- demands that in a crisis could cause distress to spread. If those resources proved inadequate, the government would likely have to step in to prevent a complete breakdown.

The clearing houses are too important to fail, and the current rules governing their risk management are too lax. Guaranty funds must cover at least two major defaults, but clearing houses are allowed to decide how much cash that actually requires -- and how much capital their shareholders should pitch in to absorb the first losses. The size of this shareholder contribution matters a lot, because the fear of loss is an incentive to be prudent in setting collateral requirements in the first place.

Some of the clearing houses' biggest users -- including JPMorgan Chase, Pimco and BlackRock -- have noted these deficiencies, and global regulators are planning to address them this year. Greater transparency and specific capital requirements would be a good start. Regulators should publicly stress-test clearing houses as they do banks, and should require them to disclose enough information to assess the quality of their risk management (a process that has already begun). Also, research suggests that shareholder contributions to guaranty funds should probably be larger than the current average of about 3 percent among the leading U.S. and European clearing houses.

Derivatives need not be "financial weapons of mass destruction," as Warren Buffett famously called them. They can make markets work better and provide useful tools for hedging risks -- as long as the right rules and incentives are in place.