The industry’s worst nightmare

Counterparty credit risk is the derivatives industry’s worst nightmare. Ever since the early 1970s, when over-the-counter derivatives began their 30-year march to replace gold as the world’s foremost financial hedging tool, it is a nightmare that has mostly remained hidden. Only in 1998, when the hedge fund Long-Term Capital Management was poised to default on its tangled portfolio of contracts, did it briefly show its ugly face, before fading amid the secrecy of a creditor bail-out.

But counterparty credit risk never went away. The laws of physics tell us that a bar of gold effectively has a zero probability of turning to lead during the lifetime of the universe. Credit rating agency Standard & Poor’s (S&P) tells us that derivatives dealer JP Morgan Chase has a roughly one in 3,000 chance of defaulting on its $25 trillion notional derivatives portfolio over the next 12 months. That corresponds to a $8 billion notional value of derivatives contracts that can be expected to