Is Wall Street already shrinking?

at 09:50 AM ET, 03/28/2012

Remember derivatives? The financial products that Warren Buffett compared to weapons of mass destruction? The ones that were at the heart of the financial crisis?
(Richard Drew - AP)

Well, they’ve been doing just fine. As recently as last spring, banks were increasing their derivatives’ holdings. But that may be changing. In the second half of 2011, the total value of derivatives contracts by insured U.S. commercial declined by 0.6 percent—the “first year-over-year decline on record,” according to the Office of the Comptroller of the Currency. The decline continued through the last quarter of 2011, when the notional value of derivatives experienced the biggest drop-off in history, falling by $17 trillion.

Why are derivatives in decline--and is it a sign that the market is becoming less risky? There are a couple of different factors at play. First, the euro zone debt crisis peaked in mid- to late-2011, making traders more cautious and stalling potential interest-rate swaps. Secondly, there’s the Dodd-Frank law and its big impending changes for the derivatives market, requiring a central clearinghouse and other measures that could put a damper on the market. The Volcker Rule’s ban on proprietary trading will also affect derivatives. Most of these rules have yet to be put into effect, as regulators are still writing them, but the combination of regulatory uncertainty and regulatory inevitability may be cooling the derivative markets as well. “Everyone is watching what the regulators are doing,” says Christian Johnson, a finance professor at the University of Utah.

There are other ways that the derivatives market has become more cautious as well, independent of the new regulations: The amount of collateral required has been on the rise, as counterparties themselves have become more risk averse. Dealers are “tearing up” trades that they initiate, mutually canceling them. “They’re protecting themselves from each other,” Johnson explains.

As a result, as well as becoming smaller, the derivatives market also became less risky: risk exposure measured by what’s known as “Value-at-Risk” dropped by 9.3 percent last year as compared to 2010. It’s unclear whether these trends will continue: the euro zone end game is still unknown, and finalized U.S. regulations could either continue to rein in the market or encourage derivatives dealers to take new risks once the new rules are set. But for the five biggest banks in the market--which hold 96 percent of all derivatives--the future may already be here.

 
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