Salmon: The $5 Trillion Dilemma Facing Banking Regulators

NEW YORK (Reuters Blogs) -- Last month, I wrote about bond-market illiquidity -- the problem that its incredibly difficult to buy and sell bonds in any kind of volume, especially if they're not Treasuries. That's a big issue but it turns out there's an even bigger issue hiding in the same vicinity.

The problem is that there's only a certain amount of liquidity to go around and under Dodd-Frank rules, a huge proportion of that liquidity has to be available to exchanges and clearinghouses, the hubs which sit in the middle of the derivatives market and act as an insulating buffer, making sure that the failure of one entity doesn't cascade through the entire system.

Craig Pirrong has a good overview of what's going on, and I'm glad to say that Thomson Reuters is leading the charge in terms of reporting about all this: see, for instance, recent pieces by Karen Brettell, Christopher Whittall and Helen Bartholomew. The problem is that it's not an easy subject to understand, and most of the coverage of the issue tends to assume a lot of background knowledge. So, let me try to (over)simplify a little.

During the financial crisis, everybody became familiar with the idea that a bank could be "too interconnected to fail." The problem arises from the way that derivatives tend to accumulate: If you have a certain position with a certain counterparty, and you want to unwind that position, then you can try to negotiate with your original counterparty -- but they might not be particularly inclined to give you the best price. So instead you enter into an offsetting position with a different counterparty. You now have two derivatives positions, rather than one. The profits on one should offset any losses on the other -- but your counterparty risk has doubled. As a result, total counterparty risk only ever goes up, and when a bank like Lehman Brothers fails, the entire financial system gets put at risk.

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