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Home > Blogs > Anthony Harrington > The warning bell on derivatives rang loud in 1994

The warning bell on derivatives rang loud in 1994

Derivatives Risks | The warning bell on derivatives rang loud in 1994 Anthony Harrington

There is an elderly document, well, not that elderly—it was written in 1994—that should be mandatory reading for global regulators everywhere. The report, by the then Comptroller General (CG) of the US, Charles A. Bowsher, was the first in-depth, detailed study of the use of and risks posed by derivatives [PDF, 13.5 MB]. In the report’s own words, the CG’s office had been asked to look into the dangers of derivatives:

“Our objectives were to determine (1) what the extent and nature of derivatives use was, (2) what risks derivatives might pose to individual firms and to the financial system and how firms and regulators were attempting to control these risks, (3) whether gaps and inconsistencies existed in US regulation of derivatives, (4) whether existing accounting rules resulted in financial reports that provided market participants and investors adequate information about firms’ use of derivatives, and (5) what the implications of the international use of derivatives were for U.S. regulations.”

These are laudable objectives. The world of 1994 was, of course, no stranger to severe financial shocks. The savings and loans crisis had cost the US taxpayer billions of dollars and it had occurred to both Congress and federal regulators that the growing use of derivatives was an area that merited some examination. The CG’s office started from the standpoint that derivatives were a good thing. They had “enabled commercial corporations, governments, financial firms, and other institutions in the United States and worldwide to reduce their exposure to fluctuations in interest rates, currency exchange rates, and the prices of equities and commodities.” That was and is a good thing, the CG says.

However, in what turned out to be a prescient insight, the CG Report added that there were concerns that “knowledge of how to manage and oversee risks associated with derivatives may not have kept pace with their increased use.” Remember, at this stage, the CG’s Office could not possibly have foreseen that the proprietary trading desk of AIG, for example, would write billions of dollars of loss-making contracts on unregulated Credit Default Swaps (CDSs), or that Lehman Brothers would get blown out the water by derivatives deals. However, the report’s authors could see the writing on the wall all right. By the year end 1992, according to the CG’s best estimates, the total worldwide volume of outstanding derivatives contracts was “at least $12.1 trillion”.

Personally, I rather like the way the CG adds “point one” to the value. My own guess is that they couldn’t have told to the nearest trillion dollars what the “real” figure was since so many derivatives contracts are one to one bi-lateral trades, and a good deal of it was never recorded in public databases—not at that time, though since then the moves to force derivatives trading to go through registered central counterparties has grown in strength.

The truly valuable part for regulators to digest as they mull over this 200 page document is that it is all there. It says everything that should be said about the dangers of derivatives, and it says it at a level that should have got a hearing and, possibly, prevented or lessened the great crash of 2008. However, the world wasn’t listening. Exuberant greed ruled the day. That’s the problem for regulators. You can talk, but can you make yourself heard?

Further reading on derivatives risks and the financial crash

Tags: Comptroller General , derivatives , economic recovery , European Central Bank , regulation , US
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