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Monitoring derivatives trading books in the current context of financial markets turmoil

The present situation of financial markets, characterised by a sharp drop of prices and a peak of volatility, was not triggered by derivatives markets but by a combination of negative news and of an extreme difficulty to make economic predictions in the current context. However, it could have consequences on derivatives markets as those conditions make the risk management of derivatives exposures particularly tricky. Supervisors should monitor the situation very closely.

Managing derivatives positions in a controlled manner requires that a number of conditions be met. Among those, two are of particular importance: 1) avoiding situations where volatility spikes go “against the book”, and 2) making sure that hedge ratios can be constantly and smoothly adjusted (derivatives traders buy or sell the assets underlying the derivatives they trade on a continuous basis for each small variation of their market prices).  When those conditions are met, derivatives trading can be a very lucrative activity but, conversely, when they are not, it can lose a lot of money.

Finance Watch, obviously, has no information on the situation of the derivatives trading books of particular institutions, but it wishes to raise the attention of supervisors as derivatives operations are treading dangerous waters. Given the current circumstances where, for instance, volatility levels have quadrupled – from around 20 to above 80 – in European equity markets in the space of a few days, and where the prices of listed securities have had a chaotic and non-continuous behaviour (jumps), the conditions for derivatives trading books to potentially lose money on a large scale are clearly met. In the specific case of equity markets, the cancellation or postponement of dividends announced for numerous listed companies is an additional factor of risk for derivatives books, given the fact that dividends are an essential component of equity derivatives prices.

The size of derivatives markets has grown out of reasonable proportions over the past 25 years: it was estimated by ESMA for the EU as having an underlying notional value of €453 trillion in 2017, and by BIS globally for OTC derivatives (i.e. excluding listed derivatives) as having an underlying notional value of $640 trillion in June 2019. A very large proportion of this huge market is traded by the fifteen biggest too-big-to-fail banking institutions of the world. This, combined with the interconnection of large banking institutions with one another, creates an environment where a serious “trading accident” (loss) in one of those institutions could have huge repercussions on the entire financial system.

In that context, Finance Watch urges banks supervisors to monitor particularly closely the derivatives operations of large banks in order to avoid that a problem always possible on a large trading book spreads to the entire financial system. This close monitoring is the price to pay, and a second best solution, for the fact that the situation of fragility created by the existence of too-big-to-fail institutions and the interconnection of the global banking system has never been resolved by regulators.

Thierry Philipponnat

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