More than five years after the global financial crisis, over-the-counter derivatives remain unstable.
Unlike equities, most derivatives are not traded on exchanges. Instead, they are merely contracts between counterparties that are extremely difficult to identify, especially during high-stress periods.
As of June 2007, the notional value of these contracts totaled $516 trillion. By June 2013, the total was $693 trillion, according to the Bank of International Settlements (BIS).
Immediately following the financial crisis in October 2008, the BIS Financial Stability Board began collecting data regarding the top 20 global counterparties. The goal was to address the key weakness exposed by the turmoil: the banks did not have consistently accurate information regarding the counterparties on trillions of dollars in derivative contracts.
Five years and three months later, Sarah Dahlgren, head of the Federal Reserve's Financial Institution Supervision Group, released a report titled "Progress Report on Counterparty Data" to Mark Carney, governor of the Bank of England and chairman of the BIS Financial Stability Board, the international regulatory body that oversees the global financial system.
The data examined in this study included over-the-counter derivatives and exposure from securities lending and repurchase agreements (repos).
"Our observations in this report indicate that firms' progress toward consistent, timely and accurate reporting of top counterparty exposures fails to meet supervisory expectations as well as industry self-identified best practices," the report stated. Dahlgren's group concluded that the banks were unable to successfully allay risk when the crisis struck due to incomplete data and untimely reporting.
"If firms cannot produce accurate data during relatively benign times, they would be unlikely to do so during periods of market stress, when exposures could be volatile and resources are operating under high-pressure conditions," according to the report.
Central storage of this information is critical if we are to prevent another crisis from developing. Unfortunately, a proper system may be several years away, according to officials.
Due to the deregulation of over-the-counter trading in 2000, regulators are unable to compel banks to provide derivatives data. The banks contend it is a costly, time-consuming and complicated endeavor to delve into the legal entities, derivatives contracts and counterparties that compose the underlying metastasis of the financial system.
The amount of outstanding derivative contracts remains near record levels since the financial crisis began five years ago. This represents a huge potential liability for the financial system and our general economy in the coming years.
If the banks refuse to cooperate, new laws may be required.
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