Credit

It is becoming more aware to us that credit derivatives may create risks to the financial markets if events prompt investors are set to exit at the same time, said European Central Bank President Jean-Claude Trichet. Investors “may react in a way that can suddenly lead to dangerous herding behavior,” said Trichet, who was speaking in Boston at the annual meeting of the International Swaps and Derivatives Association, which represents 750 banks and securities firms. “Such situations are also a matter of concern from a systemic liquidity viewpoint.”

Credit derivatives are the fastest growing financial market, surpassing bonds and loans as a cheaper way to speculate on credit quality. The market has doubled in size every year since 2003, with outstanding contracts covering $34.5 trillion of securities, ISDA said today. The decade-old market hasn’t been “stress tested” in a crisis, Trichet said.

There is potential for “counterparty risk” if investors who seek to exit at the same time, he said. Potential herd-like behavior could reduce market liquidity and affect the ability of a “significant” market participant to finance its business, Trichet said.

Such problems are low- probability events, Trichet added. The consensus view is that derivatives help efficient risk management. If liquidity were to fall, “potential loss to the financial system” would be “great,” Trichet told delegates at ISDA’s conference. “The fear is that a large proportion of market participants may have become excessively complacent.