Timothy Geithner has led efforts to manage risks to the global financial system from his days as the U.S. Treasury’s undersecretary for international affairs in the 1990s to his current work as president of the Federal Reserve Bank of New York, a position he has held since 2003. Arguably the second-most-important official at the Fed after chairman Ben Bernanke, Geithner has been pressing banks to slash the backlog of unconfirmed trades in the massive $26 trillion market for credit derivatives by automating posttrade processing. He spoke recently about those efforts and his assessment of financial risks with Institutional Investor Senior Writer Loren Fox.
1 Institutional Investor: How much progress have banks made in automating their credit derivatives posttrade processing?
Geithner: They’ve made substantial progress. The backlog of unconfirmed trades with a vintage greater than 30 days has declined by 90 percent since we started in late 2005. Most of the new transactions are now being confirmed using automated platforms in a much shorter time frame. This progress took place during a period when the overall volume of activity increased by about 50 percent.
2 What are the chances that part of the OTC credit derivatives market will move onto exchanges in coming years? Would such a move, which would centralize counterparty risk, be a good thing?
You can envision that the more easily standardized part of the market will move onto exchanges, as has happened with other types of derivatives. But the market seems unlikely to embrace a central counterparty solution in the near future. The market is now focused on ways to automate posttrade processing in credit derivatives and other OTC derivatives, which will help achieve a lot of the operational risk-reducing benefits of central counterparties without taking the next step and centralizing the credit risk.
3 What are the pros and cons of having such a large OTC credit derivatives market?
The economic and financial benefits are compelling. These markets are growing so rapidly because they are meeting a very strong demand for ways to hedge your exposure to different risks and to tailor what you hold to the risks you can understand best and manage best. This helps spread risk more broadly to a more diverse group of investors and institutions. That’s likely to produce a more stable system over time. It doesn’t mean the end of volatility or financial failures. But I don’t think the risks look particularly significant against those benefits.
4 How much of the benign credit environment is the result of the financial world’s improved risk management, and how much is because of other factors?
We don’t know, really. Answering that question is just something that central banks or governments are not particularly good at doing. The global economy has been experiencing a pretty strong and sustained expansion. Risk premia and implied volatility have declined across many different markets. This suggests there is something more going on than just greater dispersion of credit risk and better management of credit risk.
5 Does last year’s collapse of hedge fund Amaranth Advisors worry you or reassure you? Do hedge funds still pose systemic risks?
I didn’t find Amaranth particularly reassuring. There were a bunch of factors unique to that circumstance, and probably unique to markets at that time, that account for the fact that the collapse was so easily absorbed with so little damage. But I don’t think you can count on that being true under different market circumstances or if it involved a hedge fund with a different set of businesses. It’s hard to know the probability of the risk that a hedge fund’s failing could cause some damage to the financial system. We live in a system where that risk is inherent.
