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Credit risk and its management raise a paradox

Derivatives can be used to hedge risk, to speculate or, unacceptably, to cook the books. That those involved in the financial markets can simultaneously fear credit risk and the use of instruments to allay it suggests that they need to identify derivative users’ intentions more clearly.

A report on financial risk based on a survey answered by 175 bankers, regulators and corporate users was published last month by the Centre for the Study of Financial Innovation. They were asked to list the top-10 risks to the financial system. The results are paradoxical: high up were both credit risk (at number one) and, at four, the financial instruments banks have designed to cope with it. Racing up the league of perceived big risks was complex financial instruments, which went from tenth place last year to the fourth-biggest risk this year. Bankers are worried by companies' use of structured finance techniques such as swaps and synthetic CDOs to hide debt and manipulate revenues. One respondent to the survey says: "Financial derivatives are largely unregulated, untransparent and misunderstood." Another, Chris Sutton of IT company Logica, says derivatives are mainly used as a way of "circumventing regulations".

Their anxiety is shared by regulators. New measures are being considered in the US that could seriously affect both the credit derivative and securitization markets - just about the only financial markets that are booming at the moment, thanks to synthetic CDOs - by bringing special purpose vehicles back on balance sheet.

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