European Central Bank VP Sees "Perfect Storm" of Derivatives and Hedge Funds

A ``triangle of vulnerability’’ has been created by the convergence of the credit cycle, credit derivatives, and hedge funds, in the view of Lucas Papademos, Vice President of the European Central Bank. In recent remarks he noted that the growth in the volume and complexity of credit derivatives, coupled with the increasing presence of hedge funds, has posed the specter of systemic risk for the financial markets. The increasing participation of hedge funds in taking on credit risk exposures has worked a fundamental change in the methods for assessing the ability of the financial system to cope with unexpected credit cycle deterioration, he posited.

If a triggering event of sufficient severity were to occur, he said, it could bring about an abrupt increase in long-term yields, and credit and equity risk premiums across the capital markets. This would imply significant asset portfolio losses for banks and other financial institutions. More importantly, it could also raise the counterparty risks some banks face vis-à-vis hedge funds.
The senior official found it noteworthy that the collapse of Amaranth Advisors in September did not lead to wider turbulence, despite the fact that the total loss experienced by the fund was much larger than that incurred by LTCM in 1998. The ability of the system to absorb the shock demonstrated that the hedge fund sector has become more mature and has the ability to repair itself in the event of idiosyncratic distress. However, he cautioned that the Amaranth event occurred against a backdrop of benign market conditions. In a more challenging market environment, he concluded, the impact of such an event could have been more disruptive.