A dramatic dislocation

Figures released by the Bank for International Settlements (BIS) in December show just how difficult and dislocated the derivatives markets became in late July and early August 2003. There was a marked fall in turnover of exchange-traded interest rate contracts, with the value of transactions falling by more than 10%. Worst hit were short-term interest rate options, which tumbled by 33% – the largest quarterly fall for such options since the BIS began compiling figures a decade ago.

Even short-term interest rate futures, which are less susceptible to market swings, declined in turnover by 10%.

The main reason for this is well documented: mortgage-backed security investors were desperately attempting to rebalance the duration of their portfolios, straining the market-making abilities of dealers in swaps and swaptions who then retreated from the market, having no doubt incurred some substantial losses.

During this turmoil, some of the largest derivatives houses reached – and even breached – their value-at-risk limits, while just a couple of weeks earlier they had plenty of headroom.

This period of dramatic market dislocation will be the abiding memory of 2003. As the BIS has highlighted, even some of the largest banks in the world reined in their market-making, effectively telling traders to cut some of their lines.

This episode was a reminder to investment banks how quickly liquidity can dry up. And with the business of derivatives dealing concentrated among fewer and fewer players, the banks’ customers in the wider market will have learned a lesson too: the value of committed relationships.

A number of firms have achieved much in the area of risk management over the past 12 months, and their commitment to their clients and the market are highlighted in Risk’s fifth annual awards.

The aim of these awards is not simply to give the largest houses a pat on the back. They are instead a chance to commend houses that have innovated, punched above their weight or simply been the best of breed over the previous 12 months.

Morgan Stanley, Risk’s Derivatives house of the year, is notable for the enormous goodwill it has created among a range of clients. From the largest – such as Freddie Mac and the Italian treasury – to one-off clients such as the BBC, Morgan Stanley is praised for standing up to be counted when it was needed, understanding its clients’ needs and being prepared to put the firm’s capital at risk on behalf of its clients, where appropriate.

Last March, Warren Buffet described derivatives as “financial weapons of mass destruction”. Buffett was wrong, but as well as celebrating success, this magazine will also continue to draw attention to areas that have gone wrong, or could be improved – in particular the challenges of improving transparency and disclosure in over-the-counter markets.

This is why Patrick de Saint-Aignan makes an ideal choice for Risk’s lifetime achievement award – an individual who has devoted an enormous amount of his time to the betterment of the derivatives industry, and a pioneer of the opportunities risk management provides.