Counterparty risk is the risk to each party in a contract that the counterparty might not live up to its contractual obligations.  Could derivatives ever pose a potential counterparty risk for the world economy?  Former Fed Chairman Alan Greenspan indicated in 1999 that “overall, derivatives are mainly a zero sum game.”  In other words, for the most part, one party’s market loss would be the counterparty’s market gain.  If so, then one would expect that there could be little risk that the entire world could suddenly find itself bankrupt, since the total amount of world wealth would remain intact.

But is this really so?  How far is the world economy truly insulated from counterparty derivatives risk?  In these March 19, 1999 comments before the Futures Industry Association, Mr. Greenspan immediately made an exception for counterparty credit exposures in OTC derivatives, and this was an important caveat.  He said that “counterparty credit exposures on OTC derivatives are a different issue and the source of much of the systemic concerns.”  He was speaking only a few months after the hedge fund, Long Term Capital Management, had collapsed with a loss of $4.6 billion, triggering fears of a global financial meltdown.  At about the same time, due to a precipitous fall in oil prices, Russia had defaulted on its debt, and there was a global liquidity need.  In the United States, the Federal Reserve, chaired by Alan Greenspan, responded with monetary easing.

With respect to the 1990s, Mr. Greenspan noted in his speech that, “through the past decades’ phenomenal growth of the derivative market, there has not been a significant downturn in the economy overall that has tested the resilience of derivative markets.”  This was prior to the financial crisis of 2008, which finally did severely test the resilience of derivative markets, and they did not pass the test, bringing the world economy to the precipice of collapse and resulting in the necessity of bailing out several major financial institutions.

As Mr. Greenspan suggested in his speech, Over-the-counter (OTC) derivatives are a potential problem.  These are contracts that are privately negotiated and traded directly between two parties without going through an exchange.  Most derivatives such as swaps, forward rate agreements, exotic options, and other exotic derivative products, are now traded in this way.  They are not traded on any exchange, with the result that nobody really knows for certain whether they are offset by an opposing trade, or even whether there actually is an opposing trade.  It means that there is no machinery in place to calculate exposure or to guarantee offsetting trades.  It also means that there are no margin requirements.  Because they are usually customized, OTC derivatives come with their own fine print, which is so extensive that few people are able to take the time to read it, which means that it is difficult to determine the true value of an OTC derivative trade.

For these reasons, counterparty risk actually has the potential to become a very serious matter.  To make matters worse, a case may be made that even fully regulated derivatives trading on major exchanges could introduce systemic risk.  All it would take would be one major default.  If there were one major losing party who could not pay the winners, then those “winners” could actually also become losers because of counterparty default.  There are certain major banks in the world, each of which currently potentially has tens of trillions of dollars in derivatives exposure.  If there were any major counterparty default, then the result could be that a lot of winners would not get paid, creating a domino effect leading to the total collapse of the entire world economy.

It was in the mid-1990s that Blythe Masters of J.P. Morgan set up the credit default swap market in which banks began to take risk off their books by writing credit default swaps.  However, the problem since that time has increasingly been that every credit default swap has added a little more risk to the system.  Far from minimizing the risk for the banking system as was assumed, this practice may actually have brought about increased systemic risk, since every single derivative contract that has been written has necessarily increased the overall systemic risk to the financial system of any particular underlying asset.  Thus, one big default by a counterparty could destroy the entire system, because all of a sudden all the wash contracts on these derivatives would not be a wash any more.  If you are a big bank, but a counterparty defaults, then you’re still on the hook; you have made a bad bet on a counterparty which is unable to pay you, yet you’re still on the hook for the other side of the deal.

In 2008, banks such as Goldman Sachs and Societe Generale bought $62.1 billion in credit-default swaps from AIG, in effect buying protection on securities which fell sharply in value.  Goldman Sachs itself had about $20 billion in trades with AIG, and believed that this constituted $10 billion of risk to AIG, thinking that these assets could be worth as little as 50%.  Against this $10 billion of AIG risk, Goldman Sachs had $7.5 billion in collateral from AIG. The rest of the risk, $2.5 billion, was hedged with credit default swaps, in which Goldman Sachs bought protection on AIG from a variety of highly rated banks. Goldman Sachs therefore considered itself to be well-hedged, and for this reason believed that it was not at risk if AIG were to default.  But the result of this was that any crisis at AIG would become a crisis at whatever banks Goldman Sachs had used to hedge its AIG exposure. Through its purchase of protection on toxic assets from AIG and subsequent purchase of protection on AIG, Goldman Sachs created a situation in which its risk exposure to AIG became systemic risk.  At about the same time, Lehman Brothers was called to make good on some of the derivatives for which it was under water, and it couldn’t do so.   Goldman Sachs, in turn, was owed money not only by AIG, but it was also owed money by Lehman Brothers.  Goldman Sachs ended up getting bailed out with government money because AIG and Lehman couldn’t deliver on their promises.  Now, nearly a decade later, there are banks that are much, much bigger and much more problematic than Lehman Brothers ever was.  Because we have so much more debt and so many more derivatives in the system today than we did back in 2008, the world economy is far more fragile now than it was at that time.

In our own day, the problem is magnified because there are tens of trillions, if not hundreds of trillions of dollars of these derivative products in existence, used as a form of insurance.  But if something goes wrong, an institution may well discover that a counterparty is not good for the money, though it may not have expected anything to go wrong.  If an institution has written too many of these agreements, as AIG did in 2008, then all of a sudden, it would not be able to meet its obligations to other institutions which were counting on this.  Soon, in turn, such institutions would have other entities breathing down their own necks because they owe a huge amount of money to those entities, creating a chain reaction.  Derivatives therefore have the potential to create a world financial disaster because so many people mistakenly presume that their risks are insured, while they have not really adequately prepared for the type of big event during which counterparties would have no ability to pay off money when they are supposed to do so, creating a ripple effect which could topple the entire world economy.