Not waving, but drowning

An interesting article by Hamish McRae in the Sindy suggests that national banks will need to face up to the new problem of globalised inflation.

He identifies the roots of the problem as lying in two places. Low interest rates in the developed nations and excess savings from oil rich states and Asia.

But isn't the problem also structural as well? McRae doesnt really address why liquidity has become such a global issue. For a start, the level of liquidity in the market is huge, and has been so for four years. Not only that, but market liquidity volatility is low, as the graph (bank of england stability report) clearly shows.

What marks this 'boom' out, is that it doesnt have all the unpredictable characteristics of previous booms - so far, it's been stable.

The markets are certainly awash with petrodollars and Asian savings, but crucially these are being fed through an increasingly complex derivatives network that is feeding a huge credit cycle.

In very simple terms, debt instruments such as CDOs are effectively breaking down market inhibitions and allowing capital to pour into areas which might previously have been out of bounds. The credit markets have undergone a huge growth in the past four years and are starting to develop a logic all of their own. Maybe this is why inflation in the UK's economy is proving a little more resistant to interest rate hikes than previously.

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Banking on uncertainty

It doesn't really surprise me that banks are using credit derivatives as speculative levers to ratchet up their profits - as reported by the FT. It's something the industry has been doing since the market took off in the 1970s - from the liar's poker of the Solomon bond desks through to the calculated hubris of LTCM (and their starry-eyed bankers) in the 1990s.

Trading for CDS contracts has indeed been bullish, and I suspect it will only get more so with the launch of the LCDX - an index of loan credit default swaps - this week. The launch of the Index has been on the cards for some time - details were fleshed out at the LSTA conference in London mid March. It all points to even higher-liquidity levels in the secondary market.

However, the banks' growing participation in the CDS market could have more to do with the syndication process than it does with speculation. 92% of all European CDOs (the main buyers of syndicated debt) use synthetic structures - whereby the banks use CDS to transfer the risks but not the actual paper to the CDO portfolios. Thus as the syndicated market grows, so too does demand for CDS contracts.

I suspect most of the speculation being done by the banks is in arbitraging between inefficient prices in all these new instruments.

Merton - for all his skillful evasion about LTCM in the recent FT interview - was right when he said: "Derivatives are like anti-lock brake systems in a way - there is no question that they can make things safer, but only if people choose to use them that way. Often they don't - they might choose, for example, to drive faster in worse weather. Often we have chosen to use these tools not to decrease risks but to increase the benefits of taking the same risks."

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