Responsible growth

The market for over-the-counter derivatives continues to reach dizzy new highs, with total notionals hitting $236 trillion by the end of last year, according to survey results from the International Swaps and Derivatives Association, released at its annual general meeting in Singapore (see page 8). The adolescent credit derivatives market grew by 105% to $17.3 trillion compared with the end of 2004. This rapid pace of market development has caused some well-documented operational problems regarding confirmations in the credit derivatives market. As our story on page 44 demonstrates, bankers are taking different approaches to clean up their act. The ones that get it right should benefit when regulatory scrutiny turns to other asset classes such as equities and interest rates.

As our corporate survey on page 60 and our cover story on page 18 reveal, derivatives now have a much wider appeal. Corporates with asset portfolios under $50 million and municipalities - be they at state, city or school level (Moody's reckons 15% of US public colleges and universities have engaged in debt-related derivatives activity) - all use more derivatives than in the past.

In the main, that's good news. It allows end-users to customise their funding and risk management at levels they are comfortable with and which might have been unachievable in the past. Even if they are strong-armed into transactions, like Louisiana's state treasurer, John Kennedy, who, as our cover story explains, has entered into a fixed-payer swap to help that state's short-term financing needs following the devastation wreaked by Hurricane Katrina last year, it's better than some of the options available.

But there is a danger that some small end-users could utilise derivatives to deliberately fix figures in the short term. The most obvious concern stems from parties using forward-starting swaps to plug budget deficits - an ironic situation given the fierce defence mounted to stop efforts by the Reagan administration to drastically scale back the tax-exempt market to provide a short-term fix for the US deficit.

Executives sitting on the boards of municipal bodies are also concerned that swaps trade terms often lack transparency and some parties fail to fully understand the complexity of the instruments, including pricey termination fees. This can lead to an overreliance on external swaps advisers. With some large dealers trying to build their presence in the municipal market by courting these same external advisers, there is concern about the extent of their independence.

Our piece looking at how Proctor & Gamble manages risk on page 68 comes 12 years after the consumer goods group sued Bankers Trust (now part of Deutsche Bank) alleging the dealer misrepresented derivatives transactions. Gibson Greeting and Mead Corporation - two less sophisticated institutions in terms of risk management - followed suit, sparking a succession of calls for OTC derivatives regulation. Dealers would do well to heed the lessons learned from that era.