Perhaps the most surprising element of the escalating concern about mispriced and hidden risk in financial markets is the lack of focus on derivatives - so far.

But the pervasive crisis of confidence in financial markets, which is being felt most acutely in complex and opaque sectors, cannot stay away from derivatives forever. And any skepticism about the products is likely to focus on the smallest corner of the market: credit-default swaps (CDS), a class of instruments that not only is vulnerable to a troubled debt market's downdrafts but also has a troubling backlog of unsettled contracts.

Though they still make up only a small fraction of the derivative market, the weak infrastructure for trading CDS has left dealer banks struggling to keep up with an accelerating deal flow. Beyond the operational risks, there are mounting concerns about traditional credit risk: Counterparties are increasingly hedge funds that have no track record as credit insurers and arguably have little incentive to stick around if corporate defaults spike.

"It's the newest market, and I think too much faith has been placed in their ability to adequately hedge credit risk," said Joseph Mason, an associate professor of finance at Drexel University's LeBow College of Business. "CDOs and other entities used CDS to hedge the portfolios, and while they may hedge in a model, we are seeing what is ultimately a much wider magnitude move in spreads than I think those instruments were designed to hedge."

The Office of the Comptroller of the Currency estimates that banking companies held derivatives with roughly $160 trillion of notional value at the end of June; credit derivatives increased 82% from mid-2006, to $12.2 trillion.

The trading infrastructure has failed to keep pace with the huge growth in the business. The Federal Reserve Bank of New York has worked with a group of 18 dealer banks to prod them to process trades electronically and to reduce confirmation backlogs. This year the backlog of trades was whittled to acceptable levels, but a recent increase in volume has submarined dealers' efforts to keep pace with the markets.

The relative liquidity of CDS has been a key cause of the backlog. Counterparties can exit trades by selling them to someone else. As speculation in credit markets has accelerated, dealers have struggled to keep pace with the huge volume of resales, known as novations.

The backlog is worrisome because dealers and their counterparties could struggle to find each other in the midst of a credit default. "You have these transactions where the documentation is not finalized, and if you were to have a large credit event in the derivatives space, you might have people walking away from contracts," said Kathy Dick, the OCC's deputy comptroller for credit and market risk. "We saw deep markets become illiquid this summer. When people are pressed and it literally becomes a matter of whether you can execute your next trade, they will behave differently than they would in a normal market."

Dealers' ability to manage that risk is limited, because counterparties change in novated contracts.

"You can end up with an inferior credit as the obligor on your contract who you didn't pick, but the pricing doesn't reflect that," said Chris Whalen, the managing director of Lord, Whalen's Institutional Risk Analytics.

This is not a particularly opportune time for bankers to pick up additional exposure to counterparties, because the number of counterparties - mostly hedge funds - has exploded in recent years.

"Basically, anybody who can open an institutional account at a broker-dealer can trade credit derivatives," said Whalen. "The broker-dealers have been making all sorts of concessions to get the hedge funds' business."

That has raised serious questions about the value of the protection that bankers have purchased.

Banking companies "typically bought protection from hedge funds, which take the premium income and pay it out every period - it's not like they accrue reserves," Whalen said. If corporate defaults increase, "it's not apparent to me that any of these organizations are prepared to honor the obligations."

Five banking companies - JPMorgan, Bank of America, Citigroup, Wachovia, and HSBC North America - hold 97% of the notionals in the domestic banking system. Not one of those banking companies would make officials available for a substantive conversation about derivatives. Instead, press representatives cited disclosures in regulatory filings.

The filings do offer a wealth of data on derivatives, boiling down notional amounts in various products, calculating exposures, identifying loss tolerances on trading desks, and describing in general terms why they are used. But investors looking for a holistic, qualitative understanding of derivative risk are likely to remain unsatisfied.

"Trying to figure out a bank's derivative risk exposure with publicly available filings is hard and, especially if it is a big bank, may be impossible," said John H. Boyd, a finance professor at the University of Minnesota.

The bankers' unwillingness to discuss their exposure has ceded the field to conspiracy theories.

The common theme is that a dramatic collapse by a large dealer would unravel the market and take down the financial system with it. But even observers dedicated to taking a more reasoned approach offer only heavily conditioned reassurance.

"Operating on the assumption that most of the players in the market have done a reasonably good job of protecting themselves from net exposures to counterparties - either through high-quality counterparties or lower-quality parties with collateral - presumably the failure of one party is not going to have a domino effect," said Bert Ely, a banking consultant. "But who knows for sure?"

The concerns persist even though banking companies have had remarkable success controlling losses from derivatives over the past decade.

While the notional values are huge, they merely serve as a rough proxy for business volume. Of greater interest is the exposure presented by the contracts - or what bankers would be owed if all contracts were settled immediately. That number was $199 billion at June 30, including benefits from netting arrangements, in which an entire portfolio of contracts between a dealer and its counterparty are netted against each other and aggregated in a single number. The OCC estimates that at the large trading banks, collateral covers between 30% and 40% of the current exposure.

The OCC also estimates potential future exposure, which takes into account how much the values can change over the life of the contracts, at an additional $735 billion. That number are likely to swell in the coming quarters, as rate and credit volatility increase the value of the hedges that dealers and users have created.

Roughly 80% of the notionals are interest rate derivatives, and most of those are plain-vanilla swaps that are highly liquid and relatively easy to value. Despite their domination of the market, few credible experts can summon much concern about them.

Though dealer banks can get dinged by rate moves, most observers agree credit is a larger concern.

"We have no reason to think there will be a sizeable credit event," Dick said. However, "the world of structured finance is complicated - the risks move around, there are a lot of parties involved, and some of these risks can work their way back into the banking system in ways that are not always directly apparent."

The magnitude of any potential losses is hard to calculate. The worst-case scenarios indicate some banking companies - and their shareholders - could feel plenty of pain, but few paint a fire-and-brimstone picture.

In the pessimistic scenarios, "senior executives lose their jobs, and shareholders take big hits," Ely said. "And that's OK. That's the market at work. But you are not getting systemic risk, and you are not getting deposit insurance losses."

Leave it to the academics to suggest that this would be appropriate medicine for troubled markets.

"If investors do not take losses, and they are bailed out and everyone goes away happy, the products will not be improved," Mason said. "We'll put more money into existing, unstable products, setting the stage for a deeper crisis the next time around."

- By Todd Davenport, American Banker, a sister publication of Asset Securitization Report

(c) 2007 Asset Securitization Report and SourceMedia, Inc. All Rights Reserved.

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