New equity derivative worries add to investor jitters

By Jeremy Gaunt, European Investment Correspondent

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.