When Too Many People Take The Same Action, The Results Can Be Harmful

There are many activities in life that, while potentially beneficial from the point of view of any one individual, can be harmful to all when they become too popular.

For example, if one person sells a stock because he believes a company’s prospects are deteriorating, his actions may not necessarily have a long-lasting impact on the share price. However, if the majority thinks and acts like that, it can lead to a crash.

Similarly, while it is prudent for companies to guard against being left holding the bag if a counterparty goes belly up, when such efforts become increasingly widespread, it can spawn a contagious loss of confidence that has dangerously far-reaching consequences.

Based on the following report from Financial News, “US Funds Focus on Risk in OTC Markets,” it appears that things are moving in that direction.

More than half of US asset managers have tightened their risk management processes in the aftermath of the credit crunch to guard against the counterparty failures in the equity derivatives markets, according to a new report.

Nearly two-thirds of the 32 buy-side firms surveyed by US consultancy Tabb Group said the ongoing credit crisis is having a significant impact on their trading of OTC derivatives, with 57% saying the crisis has increased their focus on counterparty risk.

Large asset managers are seeking to limit their exposure to individual investment banks, while smaller funds are being forced to look elsewhere for liquidity as banks pull back capital, according to Adam Sussman, director of research at Tabb Group and author of the study.

Last month, the Counterparty Risk Management Policy Group, an industry panel composed of major banks and fund managers, urged participants in the OTC markets to step up their efforts to streamline trading and curb risk.

The panel, whose members include Goldman Sachs (GS), HSBC (HCS) and Morgan Stanley (MS), recommended that participants develop standard practices to determine the value of trades when a major counterparty defaults. It also called for the launch of a central clearing house for credit default swaps by the end of the year to protect participants against the consequences of a collapse of one of their number.

The funds surveyed by Tabb agreed that the trading and processing of equity swaps and OTC options need to become more efficient to address problems such as erroneous information, repetitive data entry and lack of standards.

However, the survey found the migration of OTC trading onto an exchange or the introduction of a central clearing facility would be too costly for many buy-side firms. “There is no perfect or ideal market structure,” Sussman said.

The equity derivatives market has expanded at 27% per year on average over the past decade, as buy-side firms seek to differentiate themselves by moving into the space, the report said.

“While it may be no surprise that nearly 50% of hedge funds today trade equity swaps or OTC options, a growing number of asset managers, including long-only fundamental shops, indexers and private wealth divisions of regional banks, hold sizable equity derivatives positions as well,” Sussman said. “The flexible nature of derivatives has attracted the broad asset manager demographic.”

The research was based on interviews with 17 investment managers and 15 hedge funds with a total $6.35 trillion (4.5 trillion) of assets under management.

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