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I spent about 10 years of my professional life in the derivatives business. It was intellectually stimulating. It was fun. It was frustrating. And it could be gut-wrenching. And it is the gut-wrenching part that I'd like to discuss in this post.

When markets-types throw around the term "OTC derivatives," it conjures up an image of trillions of dollars of customized contracts helping to distribute risk across the business and investment landscape. And this is true - derivatives are amazing and powerful tools for hedgers and speculators alike. But from the dealer side, it is a little more complicated than that.

Because many, if not most, of the risks being booked by Wall Street derivatives desks are not perfectly offset through hedging activity, either by necessity (there simply are not perfect offsets available) or intent (because I may view the position as a cheap way to buy volatility, convexity, etc.).

Consider this: From a hedgers perspective, if the risks in question could be easily hedged in the listed markets, why would anyone use the OTC markets? Stealth, to be sure. But I'd argue that most of the time it is because what a hedger wants to hedge is not readily available in the listed markets (due to size, underlying, timing, etc.), which means, by definition, that the dealer is taking on some residual risks that need to be dealt with. And if there aren't perfect offsets available, what does this mean in terms of risk management and revenue recognition for Wall Street dealers? Good question; I'm so glad you asked.

Without getting too technical, there are a bunch of residual risks that exist after an OTC derivatives transaction is entered into, some of which are relatively easy to hedge and others of which - well, let's just say they are somewhat more tricky. And let's for the moment consider transactions that involve optionality, because this is where we'll have the most fun (hedging interest rate exposure using swaps is far, far less interesting, and I wouldn't want to bore you, would I?).

You've got time to maturity (theta). You've got interest rates (rho). You've got change in the value of the underlying hedged asset (delta). You've got volatility (vega or kappa, depending upon whether you are from the Chicago School or not). And you've got those other higher-order risks that, when spread across billions if not trillions of notional really begin to add up, like gamma. Like correlation.

Suffice it to say, this is pretty complex stuff. Complex from a risk management perspective. Complex from a control perspective, as it relates to how revenues are permitted to be recognized by the control functions of Wall Street firms. And much of this complexity relates to the non-linear way in which these risks manifest themselves, i.e., with an option approaching maturity, and with the hedged underlying (i.e., the S&P 500 as it relates to, say, S&P 500 index puts) fluctuating around the strike price, the required hedge can flip from 100% to 0% and back almost instantaneously. And this is where dealers can hemorrhage big, big cash, really, really fast.

But wait, there's more. What about when the entire dealer community is caught leaning a particular way, for instance, in the selling of index puts, in size, to asset hedgers wishing to put on a portfolio hedge in a frothy yet jittery market. Sure, you can do some of this hedging in the listed markets, but generally not to the full extent of hedger demand. This very issue was raised in this weekend's Barron's.

Even though its activities are often secret, OTC options trading influences the futures, options and stock markets. Investment banks transfer the risk they shoulder from creating these custom options to options market makers at exchanges. Those market makers, in turn, then trade futures contracts. All of this action ripples into the stock market. The risk embedded in the OTC index puts created and sold during May, for example, were hedged with S&P 500 December 1200 and December 1400 puts, which have enormous open interest.

And while this is certainly true, it doesn't begin to explain the full exposure borne by the dealer community. A dealer might "box off" (or attempt to completely offset) a portion of the risk of a sold option trade by hedging with the listed contracts, but this is generally just for a part of the position. And then there are the natural exposures embedded in the dealer's book which may further offset risk of this short option trade. But again, there is often, and sometimes substantial, residual exposure that manifests itself in the delta, vega and gamma of the trade. And this is where it can get ugly. Especially when the Street is collectively leaning in one direction. We've seen it happen with credit spreads. And we have and will continue to see it in derivatives transactions.

When one set of hedgers wants to do something, often many others will try and do the same thing. And this is when market dynamics get skewed, sometimes causing volatility to get artificially depressed (due to dealer risk management activity) before it explodes in the wake of a shock. And then you have a lot of people - on dealer trading desks - trying to get through a very, very small door, through which only a few can make it. And this is when the pain begins.

Wall Street risk management practices and infrastructures have been substantially upgraded over the past 10 years, partly due to the fact that risk manager compensation levels have shot up as its importance in the money-making process (either by protecting against financial loss or guarding against the "headline risk" of a blow-up) has become apparent. And this is completely appropriate, and more so due to the skyrocketing OTC derivatives volumes churning through the system. The question is: what is the true extent of the residual exposures being borne by the Wall Street dealer community, and how is revenue being recognized relative to the ongoing exposures carried in dealer trading books? VaR won't tell you. These numbers simply aren't available. This is just something to keep an eye on as more and more asset hedgers look to buy optionality. Because someone will be booking these hedges. And they will be in sizes far in excess of those available through the listed markets. Which leaves the dealer community.

I have just one thing to say: If you are going to swim in the shark tank, you've got to know where ALL the sharks are. Because if you miss even one, well... And this applies to more than just derivatives. Remember the VNU bond-holders fiasco, where a private equity-proposed leveraged buyout that intended to leave existing debt outstanding caused CDS spreads to blow out by 250 bps practically overnight? Sure sucked for existing bondholders, right?

Well, this kind of outcome was possible given the bond covenants and, therefore, it happened. Surprise, surprise. But it shouldn't have been. It wasn't like a debt-funded VNU buyout was some three-sigma possibility. Then why did spreads blow out so much? Because bondholders didn't anticipate that they would get jammed. But it is a gentleman's market no more, my friends. The risk existed and VNU bondholders simply didn't price it properly. Ok, but that's kind of the game, isn't it? And now we see something similar happening with the subprime mortgage meltdown. As outlined in yesterday's Financial Times:

In the latest twist to the tale, it emerged last week that a group of US hedge funds were up in arms over the banks’ involvement in derivatives based on sub-prime mortgages. The banks both create and sell the derivatives – which offer insurance against mortgage default – and manage the mortgages. The hedge funds say they have been relaxing terms on defaulting mortgages so they will not have to pay out on the derivatives.

Leaving aside the unappealing spectacle of America’s richest – the hedge fund managers – betting on the poorest losing their homes, the question is how the banks can wind up writing insurance against risks that they themselves partly control.

There are two issues raised here. The first is around the issue of hedge funds being pissed off at the banks for being on both sides. Well guys, sorry to say but banks are going to act rationally. They will look at the entire picture, not each picture in isolation, and if that means taking mark-to-market losses on their mortgage portfolio to protect the value of derivatives contracts, that's exactly what they should be expected to do. It is not as if the hedge funds entering into these derivatives didn't know that banks originate and underwrite mortgages which they often package, structure, and sell, as well as write derivatives against.

So given this knowledge, is it reasonable to expect that hedge funds should have priced in the possibility of banks' optimizing their own outcomes to the detriment of derivative holders? I'd say so. Everyone at the table is a shark, and to expect anything less is just silly. So please, no more tears. The best funds make money off of people and firms mispricing risks, and if every once in a while this principle comes around to bite them in the rear, it is just the cost of swimming with the sharks.

The second issue relates to how banks can write insurance against risks they themselves partially control. The answer: because they can and because hedge funds and others buy it. The banks aren't holding a gun to anybody's head. The question is, on its face, just ridiculous. There either is or is not a market for something, and in the case of banks selling mortgage derivatives, there is. So end of story.

The financial markets are tough, my friends. One should assume that homework poorly done will eventually result in one's getting smacked. There are just too many smart people with too much money looking for ways to squeeze blood from a stone.

Source: OTC Derivatives: Risks and Rewards