New equity derivative worries add to investor jitters

LONDON (Reuters) - Equity markets could be in for yet more volatility as investment banks sift through billions of dollars in derivative dealings, adding another new worry for investors on top of fears about credit and recession.

Following Societe Generale's (SOGN.PA) disclosure last week of a $7 billon (3.5 billion pound) equity derivative loss, investment banks are scrutinising their risk management systems, potentially including a root and branch look at their holdings.

"It definitely shook up every risk managment department in the market," said Eric Boess, global head of derivatives for Allianz Global Investors.

In addition, there was huge spike in derivatives volume triggered as markets reacted to the SocGen scandal.

Some of it has yet to work its way through the system because of a huge backlog in deal confirmations in parts of the derivatives market.

The potential risk for equity investors is that banks find some mismatches in their derivative trades -- holdings without an appropriate hedge -- that prompt them to take an opposing position and trigger more equity volatility.

In a climate of reduced appetite for risk, banks could well also err on the side of caution.

This is not to say that investors are expecting another scandal anything like that at Societe Generale. That is widely viewed as a one-off event involving a rogue trader.

Nor are they expecting any derivative selling that may come to be as disruptive to markets as SocGen's was -- the bank disposed of 50 billion euros worth of paper over three days, as much as 8 percent of total volume in some parts of the market over the period.

So large was the move that it is being blamed for the sharp losses on equity markets early last week that are, in turn, widely believed to have tipped the U.S. Federal Reserve into an emergency 75 basis point interest rate cut.

One derivatives specialist who asked not to be named was scathing about the way SocGen "dumped" so much onto the market over such a short period.

He said he could not imagine others now making similar moves that would create such technical volatility.

TROUBLE AHEAD?

The potential is there, nonetheless, for more ructions.

For one thing, the size of the equity derivatives market, while dwarfed by those for interest-rate and credit derivatives, is large and growing.

According to the latest available figures from the International Swaps and Derivatives Association, the notional value of outstanding equity derivatives -- swaps, options and forwards -- hit $10 trillion by the middle of last year.

It was a 39 percent increase over six months, giving the market a value more than twice the size of the Japanese economy.

In the meantime, Jonathan Davies, co-chief executive of Derivative Consulting Group, reckons some of the fallout from the SocGen debacle may yet to be seen.

The issue involves over-the-counter equity derivative trades, which are not conducted through exchanges. These are subject to settlement backlogs.

Davies said the news about SocGen last week caused derivative volumes to "go through the roof" and that the number of outstanding confirmations of OTC deals would have gone up accordingly and are still working their way through the system.

"The problem will come in three to four weeks," he said, referring to the period when internal reporting procedures will show confirmations that have been outstanding for 30 days.

VOLATILE INVESTORS

None of this would be particularly worrying if it were not for the fact that equity market volatility is already soaring.

With investors battered by concerns over credit derivative losses and a slowing world economy with the United States potentially heading into recession, stock markets have been on a generally downward roller-coaster ride.

Germany's DAX-New Volatility index .V1XI is up more than 75 percent this month.

The better-known VIX index .VIX, the so-called fear gauge for the U.S. S&P 500 index .SPX, is up a more modest 21 percent. But that is mainly because of gains registered at the end of last year and it is at levels similar to those in the run-up to the 2003 Iraq war.

"The risk premium reflected in the implied volatility is still quite high. Historically, we have seen the risk premium decrease in January as risk appetite increases in the new year," said Aaron Brask, head of equity derivatives research at Barclays Capital.

"That did not happen this year and indicates just how much uncertainty there is in the markets."

Equity derivatives are now adding more to the mix.