Derivatives at Davos

Back in December of 2004, in a weblog entry entitled The Basel Accord and the Value at Risk (VaR), I wrote the following:

While the advance in synthetic financial derivatives have allowed hedging of bets across the board and through the wide range of financial institutions, since these derivatives have also led to greater interlocking and entanglement of all aggregate financial bets across institutions, they may leave the whole system under a larger meta-level risk. The only breathing space left as an influence factor seems to be how the system is connected and interacts with its "edges" such as the emerging economies. In other words, while entanglement of bets has led to greater distribution of risks into a lower overall risk aggregate, the boundaries still determine how stability may "leak."

Now, at the Davos 2007 World Economic Forum, Jean-Claude Trichet, the president of the European Central Bank seems to be moaning the opacity of fancy derivatives and hedge funds who use them. Trichet spoke as part of a session dedicated to whether central banks could manage global financial risks. As reported by Financial Times from Davos:

Conditions in global financial markets look potentially “unstable”, suggesting investors need to prepare for a “repricing” of some assets, Jean-Claude Trichet, president of the European Central Bank, said over the weekend in Davos ......

“There is now such creativity of new and very sophisticated financial instruments ... that we don’t know fully where the risks are located.” He added: “We are trying to understand what is going on but it is a big, big challenge.”

Mr Trichet’s comments reflect a debate in policymaking circles about the implications of the growth in derivatives.

Many investment bankers and some regulators and economists argued at last week’s World Economic Forum in Davos that the growth of the $450,000bn (€350,000bn, £230,000bn) derivatives sector had helped reduce market volatility and made the system more resilient to shocks by spreading credit risk. But other officials fear these instruments may be raising leverage and risk-taking to dangerous levels and keeping the cost of borrowing artificially low, potentially increasing the chance of financial crises.

I have to say that at least in my 2004 blog entry, I had some conjectures regarding the form of the risks and how they may leak out of the system so tightly bound together in hedges, bets and counter-bets.