FYI: An Update on Emerging Issues in Banking

Derivatives Risk in Commercial Banking

March 26, 2003 

Summary

Derivatives activity at commercial banks, as measured by total notional values of over $56 trillion 

as of December 31, 2002, continues to grow dramatically. Derivatives serve an essential role in 

the U.S. and world economies but also present certain risks to the deposit insurance funds. This 

FYI explains what these risks are and describes how they are managed within commercial 

banking. 

Derivatives: What They Are and the Role That They Have in the Economy

Derivatives are financial instruments or contracts with values that are linked to, or derived from, 

the performance of underlying financial instruments, interest rates, currency exchange rates, or 

indexes. In a simplified sense, a derivative links its holder to the risks and rewards of owning an 

underlying financial instrument without actually owning the financial instrument. 

Derivatives are important to the financial markets and the world economy because they provide 

a means for companies to separate and trade various kinds of risks. The ability of participants in 

the financial markets to adjust specific risk exposures enhances the efficiency of capital flows by 

allowing companies to conduct business activities without amassing certain risks that would 

otherwise attend that business. For instance, mortgage lenders that are comfortable with the 

credit risk of mortgage lending may be less comfortable with the amount of exposure to interest 

rate movements that accompany a large mortgage portfolio. A mortgage company can use 

derivatives to lessen their exposure to the effect that interest rate movements might have on the 

value of their business and continue to make mortgage loans. Mortgage borrowers benefit from 

these arrangements because mortgages are cheaper when lenders have choices about the risks 

that they retain. 

Notional Amounts Measure Derivatives Activity Not Risk

At $56 trillion—a dollar figure that is more than five times GDP—the notional amount of 

derivatives outstanding can seem daunting. However, the notional amount of a derivative 

contract is merely the reference point to the underlying instrument. It serves as the basis for 

calculating cashflows under the contract. For example, a very typical derivative contract would 

be to pay the 10-year Treasury rate on $1 million in return for a floating rate on the same 

amount. The notional amount of the contract is $1 million. This amount does not change hands; 

but for each payment period, the 10-year Treasury rate is multiplied by $1 million to calculate the 

fixed-rate payment. 

While the notional amount is a proxy for the amount of derivatives activity, it does not measure 

the riskiness of the activity. The notional amount itself is seldom at risk of loss with derivatives. 

Instead the derivatives investor is at risk of loss from changes in prices of or rates earned on the 

physical or financial assets that the notional amount represents. 

When the derivatives market as a whole is in view, it is important to consider that offsetting 

positions that add to gross notional amounts do not necessarily add significantly to total market 
risk. This concept is illustrated in Transaction Scenario 1. 

Transaction Scenario 1:

A derivatives transaction example that illustrates the relationship between notional 

amounts and potential risk.

An American firm holds $2 million in cash. This company is planning to buy equipment from a 

German manufacturer six months from today that, given today's exchange rate, is valued at $2 

million US Dollars (USD). 

Given its plans to purchase this equipment, its cash position in USD actually represents a 

foreign exchange (FX) exposure to the exchange rate between USD and German marks (DM). 

The firm calls a derivatives dealer and enters into a FX contract that obligates the firm to sell 

DM six months from today at today's exchange rate. In so doing, the American firm locks in the 

USD price of the equipment, thereby hedging its foreign exchange risk. If DM appreciate, the 

equipment becomes more expensive in terms of USD; but the firm profits in its derivatives 

contract by roughly the same amount.

After entering the transaction with the American firm, the dealer bank enters into a contract with 

a hedge fund to sell DM six months from today at today's exchange rate, thereby completely 

offsetting its exposure to the exchange rate between USD and DM. In actuality, the exchange 

rates used on both sides of the transaction might be slightly different, allowing the dealer bank 

to make a spread on the transaction to compensate it for making a market in DM forward 

agreements.

The hedge fund enters the transaction because its managers believe that DM will weaken 

against USD in the next six months and the fund is willing to speculate in order to profit from 

that movement. 

In terms of the gross notional amount of derivatives outstanding in the banking system, the 

transactions in this example contribute $4 million: the sum of both the bank's FX contracts. In 

terms of market risk, these transactions contribute nothing. There is, however, credit risk 

associated with the dealer bank's position. While the transaction is open, the exchange rate 

that the market expects between DM and USD may change. If DM depreciate (a change

unfavorable to the American firm's FX derivatives position), then the contract between the 

dealer and the American firm increases in value to the dealer. This increase in value and 

potential future increases in value during the contract's life represent credit exposure of the 

dealer to the American Firm. 1

While Derivative Notional Values have Grown, the Number of Banks Involved Has Not

The vast majority of U.S. banks manage their interest rate and other risks within their balance 

sheets and do not use derivatives. As of December 31, 2002, 439 institutions or 5.6 percent of 

commercial banks held some amount of derivatives. The percentage of banks holding any 

derivatives peaked at a little more than 7 percent in the third quarter of 1995. 

Chart 1 shows the growth of the notional value of derivatives divided into three broad categories 

of underlying instruments: interest rate contracts; foreign exchange contracts; and equity, 

commodity, and other contracts.2 The extraordinary growth in notional values is due to the 

growth of interest rate contracts, which, as of December 31, 2002, amounted to a little over 86 
percent of the $56 trillion derivatives market.

D

The Nature of Derivative Activities in Commercial Banking

There are three broad kinds of derivatives activities: hedging, dealing, and speculating. While 

each of these activities is found to some extent in commercial banking, dealer activities 

dominate. 

When used for hedging, a derivative position is employed to offset or reduce the risk associated 

with an existing balance sheet position or future planned transaction. Dealing in derivatives 

consists of taking an intermediary role and making contracts available for customers to earn 

fees. Dealers may enter into offsetting positions with other customers or manage derivatives risk 

in other ways. Speculators enter derivative transactions in order to profit from expectations that 

are different from the market's expectations about how derivatives prices will move.

Most commercial banks enter derivatives transactions as hedgers or dealers. In terms of notional 

amounts outstanding, derivatives activity is highly concentrated at dealer banks. In terms of the 

number of institutions holding any amount of derivatives, most are hedgers using interest rate 

contracts. The extent of speculation within commercial banking is more difficult to determine 

because it is not reported as such and speculative-type risks arise from certain dealer activities. 

A Risk Ranking of Derivatives Activities

The risk associated with hedging, dealing, or speculating varies substantially. While poorly 

managed operational risk could lead to losses in any derivatives activity, a generalized rank 

ordering of derivatives risk can be constructed. Generalizations about the rank ordering of risk 

are helpful in understanding the nature and source of the risk inherent in the $56 trillion of 

notionals outstanding. Diagram 1 provides a grid for considering the rank ordering of risk in the 
derivatives market. 

D

Transaction Scenario 2: A derivatives transaction example that illustrates how a 

derivative's riskiness is related to the volatility of the factors that determine its value and 

the sensitivity of the derivative to changes in those factors.

Transaction 1: An Interest Rate Swap

Party A agrees to pay party B a fixed rate of 6 percent and receive from party B the 3-month 

Treasury rate for a period of 2 years beginning November 15, 2000, on a notional value of $1 

million. Party A would enter such a transaction either to profit from a view that rates were going 

to rise or to hedge a balance sheet position that was subject to erosion in value if rates were to 

rise, such as holding Treasury bonds. If the short-term rate falls, Party A will lose on its 

derivatives position. Assuming for simplicity that the 515 basis point decline in 3-month 

Treasury rates that actually occurred during this contract period was evenly distributed over the 

two years, Party A would have lost a little more than $57 thousand in the transaction—less than 

6 percent of the notional value. 

Transaction 2: An Equity Contract

Party A agrees to pay party B a fixed rate of 6 percent and receive from party B the return on 

the NASDAQ composite for a period of 2 years beginning November 15, 2000, on a notional 

value of $1 million. Assuming, again for simplicity, that the almost 45 percent decline in the 

NASDAQ that actually occurred during the contract period was evenly distributed over the two 

years, Party A would have lost almost $343 thousand in the transaction—more than 34 percent 

of the notional value.

The relative risk of these two contracts is apparent when one considers the historical changes 

in 3-month Treasury rates versus the historical changes in NASDAQ returns and the impact 

that these changes have on the gains and losses associated with the derivatives position. 

Although short-term rates moved significantly during the past several years, these changes are 

eclipsed by the changes in NASDAQ return during the past several years.3

Contract Type Risk Ranking

Transaction Scenario 2 illustrates why interest rate contracts generally are less risky than other 

derivative types, such as equity derivatives contracts. Despite the changes in short-term rates 
described in the scenario—which were large by historical standards—losses on the interest rate 

contract are a small percentage of the notional amount. An exposure to the NASDAQ during the 

same time period resulted in a loss that amounted to a significant percentage of the notional 

value. Commodity contracts can resemble equity contracts in terms of riskiness.

Although foreign exchange and interest rate contracts enjoy many theoretical similarities, the 

placement of foreign exchange contracts above interest rate contracts in the risk matrix reflects 

greater inefficiency in the foreign exchange market and the fact that with foreign exchange 

forward contracts, although the notional amount is not contractually at risk of loss, it is frequently 

exchanged. This exchange could increase the operational and credit risk associated with the 

transaction. 

Activities Risk Ranking

The relative riskiness of the major derivatives activities relates to several attributes of each 

activity. By definition, hedging is a risk mitigating activity. Although it is not without its risks, these 

risks, which are discussed below, are small relative to the other derivatives activities.

Derivatives dealers are exposed to at least the same risks as hedgers, and they incur additional 

operational risks as a result of the sheer volume of derivatives activity they undertake. 

Furthermore, the strategies used by dealers in managing derivatives positions are not of equal 

risk and some strategies can result in speculative-like risks. Dealer strategies are discussed 

below. 

Pure speculation in derivatives can be extremely risky because derivatives can facilitate 

magnified risk exposures and high leverage from a capital standpoint. For example, derivatives 

can be fashioned that allow speculators to be highly exposed to risk with very little capital or 

cash investment. Due to the leveraged nature of the investment, relatively small unexpected 

changes in underlying values can compromise a speculator's capital base.

The Extent and Risk of Hedging 

The primary risk of hedging lies in the potential for correlations between the derivative 

value and the hedged item to change from what was observed or assumed when the 

hedge was constructed.

In terms of the number of institutions holding derivatives, a vast majority of the banks that use 

derivatives (339 or 77 percent) hold them solely for hedging purposes. However, in terms of 

dollar volume, these hedging-related holdings amount to less than one half of one percent of 

total notionals. Most of the derivatives (90 percent) held for hedging purposes are interest rate 

contracts, indicating that banks are mostly using derivatives to hedge interest rate risk. 

Derivatives held for hedging purposes may be somewhat more than indicated by this number. 

Banks that are motivated to hold derivatives for hedging purposes may use a trading account for 

accounting reasons. Under Financial Accounting Standard (FAS) 133, the hurdle for using hedge 

accounting is higher than it was previously. For example, so-called macro hedging does not get 

hedge accounting treatment under FAS 133.4 Without hedge accounting, a company's earnings 

are subject to additional volatility due to the marking of the hedge to market without marking the 

"hedged" assets or liabilities to market. To avoid this earnings volatility, a company might 

establish a trading account and hold both the derivative hedge and the hedged balance sheet 

items in the trading portfolio where both are marked to market and the gains and losses that run 

through earnings are mostly offsetting. 

The risk of hedging lies mostly in how much the value of the derivatives contract varies in 
relation to the value of the hedged item. This relationship is referred to as correlation. The least 

risky hedge exhibits relative price movements between the derivative value and the hedged item 

that have been consistent over time and that are close to completely opposite, that is, the price 

movements have tended to offset one another over time. 

The risk that hedgers face was exemplified during the market disruption that followed the fall of 

Long Term Capital Management and Russia's debt default in the last several months of 1998. 

The spread between mortgage rates and 10-year treasury securities widened unexpectedly 

during this time. Traditionally, hedgers of certain mortgage-related products rely heavily on the 

stability of the relationship between these rates. 

When this relationship destabilized, hedges performed in ways that were not predicted, and in 

some cases, would-be hedgers experienced losses on both the derivatives contract and the 

asset it was intended to hedge. 

One measure of the significance of derivative hedging activity for an institution is its effect on the 

bank's income. Hedging has a significant impact on net operating income at several institutions. 

As of December 31, 2002, 23 banks that use derivatives to hedge, reported an effect from 

hedging that amounted to more than 10 percent of net operating income during the fourth 

quarter of 2002. 

The Extent and Risk of Dealing in Derivatives 

Nearly 81 percent of the $56 trillion notional value of derivatives represents interest rate 

contracts at five dealer banks.

The top 5 derivatives dealers hold 93 percent of total notionals.5 More than 86 percent of these 

dealers' holdings are interest rate contracts. Therefore, in terms of the derivatives risk matrix, a 

vast majority of commercial bank derivatives activities is in interest rate contracts at a few dealer 

banks.

These dealers conduct derivatives activities as part of their total trading operations, which makes 

analyzing derivatives risk difficult to isolate from total trading risk. Furthermore, if a bank is 

speculating in derivatives, it occurs within these trading portfolios and is not reported separately. 

In customer-related derivatives trading activities, banks engage in some combination of matched 

trading, market making, and positioning.6 The relative mix of these three methods, to a large 

extent, determines not only the magnitude of the market risk of the individual bank's derivatives 

trading but, because of the derivatives dealers' market dominance, this mix also drives total 

derivatives market risk in commercial banking. These trading methods are discussed below in 

order of increasing risk.

Matched Trading

When matched trading, a dealer enters into a trade with a customer and then enters into an 

equal, offsetting position with another counterparty. A dealer bank that uses matched trading to 

manage market risk eliminates most of the market risk of its activities. The effectiveness of 

matched trading in controlling market risk is considerable because its effectiveness does not rely 

on model accuracy to the extent that other methods of controlling market risk do. Errors in 

modeling the market values of one side of the transaction are likely to be counterbalanced by 

offsetting errors on the other side of the transaction. Although market risk may be neutralized in 

matched trading, the trading bank retains credit risk on both sides of the transaction. 

Market Making

Market makers stand ready to enter into certain contract types without regard to whether they 
have an offsetting transaction. In accumulating inventory during a given day, intra-day positions 

develop that result in market risk. Market makers are compensated for market, credit, and 

liquidity risks through the bid/ask spread, and may experience additional profits or losses from 

this intra-day positioning. A bank's success in market making depends on the accuracy of its 

pricing models. Unlike the matched trader, the market maker is likely to be subject to 

unfavorable movements in their markets that occur during the day. Generally, a market maker 

will significantly offset these risks at the end of the trading day.

Positioning

Positioning occurs when a trader, perhaps expecting favorable market movements, executes a 

transaction with a customer without establishing an offsetting position. Other reasons to maintain 

open positions include the need to maintain an inventory of financial instruments for distribution 

to customers, the existence of a large position from a customer transaction that takes time to 

close out, and the need to aggregate a sufficient number of small transactions to be 

economically efficient to hedge. Unlike the market making strategy, these positions can be 

carried over for more than a day leaving more time for the markets to move unfavorably. 

Positioning embodies speculative-like risks that need to be monitored and controlled carefully.

Speculative and Proprietary Trading

Speculative and proprietary trading are distinguished from other trading activities in that they are 

not initiated to serve customers. A bank engages in speculative trading for the sole purpose of 

increasing its earnings. A bank may engage in proprietary trading for a number of other 

reasons.7 Among these reasons are to increase experience and expertise in the markets, and to 

diversify risks associated with other trading positions.

Types of Risk at Dealer Banks

Dealer banks face three major risks from derivatives activities. These risks are market risk, credit 

risk, and operational risk.

Market Risk

The magnitude of derivatives market risk in commercial banking is largely related to the 

extent to which the major dealers engage in matched trading, market making, or 

positioning.

At any given time, dealers may be simultaneously engaged more or less in matched trading, 

market making, or positioning as their business strategies dictate. It is difficult to know the extent 

to which the activities of each dealer fall within these categories at any point in time. However, 

the market values of a bank's derivatives portfolios may provide information, albeit imperfect, 

about the bank's activities. Derivatives contracts may have negative or positive market values. 

When positively valued, the amount represents the dealer's cost to replace or duplicate the 

contract. When negatively valued, the amount represents the cost that the dealer would incur to 

exit the contract. Derivatives portfolios that are equally weighted with negatively valued and 

positively valued positions would characterize a matched trading strategy. For example, in a 

matched transaction where the derivative positions are mirror images, at any point in time the 

sum of the total position should be very close to zero. This is because market moves against one 

side of the transaction will be favorable to the other side. Extensive positioning would result in 

larger differences in the positive and negative values of derivatives in a portfolio, and would at 

least indicate that the bank is managing its market risk using techniques other than matched 

trading. Extensive use of other techniques requires a high degree of confidence in the reliability 

of the models that the banks use to manage market risk. In liquid markets, the bank has the 

benefit of observable trades to benchmark the accuracy of their models. However, when dealers 

take positions in less liquid contracts, they should be conservative regarding the extent of those 
position and the degree of faith they place in the accuracy of their models. 

In Table 1, a calculation based on a bank's reported market values of derivatives holdings is 

used as a proxy to estimate the extent to which the bank is not using matched trading to manage 

its market risk.8 Using this proxy technique, in the aggregate, commercial banks have 

unmatched market values totaling $33 billion. Three of the five dealer banks have unmatched 

market values that account for over 88 percent of the commercial bank aggregate. While this 

calculation could reveal apparently open positions, it should be interpreted with care. Banks may 

have positions in nonderivative assets and liabilities that either exacerbate or mitigate their 

derivatives positions.

Table 1: Contract Market Values: Positive Values Net of Negative Values by Contract 

Type

Name

Interest 

Rate 

Contracts 

(PositiveNegative)

Foreign 

Exchange 

Contracts 

(PositiveNegative)

Equity 

Contracts 

(PositiveNegative)

Comodity 

& Other 

Contracts 

(PositiveNegative)

Absolute 

Value of 

Net 

Positions

Tier 1 

Capital

Absolute 

Value of 

Net 

Position 

as a 

Percent 

of Tier 1 

Capital

JPMorgan 

Chase 12,237,000 (3,746,000) 357,000 1,086,000 17,426,000 31,908,000 55%

Bank of 

America 3,704,000 (2,034,000) (330,000) (1,678,000) 7,746,000 33,420,000 23%

Citibank 5,071,000 124,000 428,000 (2,000) 5,625,000 39,897,000 14%

Bank One 

NA 703,000 (44,000) 48,000 26,000 821,000 16,888,000 5%

Wachovia 

Bank NA (341,000) (66,000) 225,000 - 632,000 18,594,000 3%

D

Most of a bank's dealer business may occur in easily managed products, such as plain vanilla 

interest rate swaps. In fact, most of the $56 trillion in outstanding notional values falls into this 

category. However, earnings pressure may motivate dealing in riskier products. The high liquidity 

and common understanding of easily managed products lowers the risk of dealing in them but 

also limits the potential return. In order to earn a greater margin on transactions, a bank would 

likely need to take on more complex transactions that are more challenging to manage. A bank 

that has demonstrated a propensity to take on additional risks under earnings pressure would 

seem more likely to have engaged significantly in complex derivatives activities that exceed the 

comfort level of its risk managers. A bank supervisor's familiarity with the risk management 

culture at a dealer is a key control of risk of this nature.

Credit Risk 

While concentrations of credit from derivatives counterparty risk may appear significant, 

concern is mitigated by the diversity and credit quality of the counterparties and the 

nature of the transactions.

Dealers that limit market risk by maintaining a reasonably matched derivatives portfolio still 
retain significant counterparty credit risk in derivatives transactions. Credit risk in a derivatives 

transaction has two components: current exposure and potential future exposure. Current 

exposure is represented by the fair value of a bank's derivatives contracts that have a positive 

value. The exposure represents the cost of replacing the contract if the current counterparty is 

unable to perform. Potential future exposure represents an estimate of the replacement cost that 

a contract could have during its remaining life, which is often difficult to estimate with much 

reliability. For risk-based capital purposes, potential future exposure is estimated based on 

several principles. The shorter the time to maturity, the less opportunity a contract will have to 

fluctuate in value. The greater the price volatility of a contract type, the greater the expectation 

that its change in value may result in a credit exposure over its life. Although a contract that 

currently has a negative value poses no current credit exposure, it still carries potential future 

exposure because market factors may reverse during its life.

Banks are frequently able to net positions that are open to the same counterparty and reduce 

credit risk exposure. For example, if a bank has two contracts with the same counterparty—one 

with a negative fair value and one with a positive fair value—a bilateral netting agreement would 

allow the bank to consider the current exposure to this counterparty as the net fair value of these 

positions. For the large dealers, netting agreements significantly reduce the credit risk exposure. 

For example, JPMorgan Chase has derivative contracts with positive fair values totaling over 

$623 billion. When netting agreements are considered, the total current credit exposure is 

reduced by more than 86 percent to $87 billion.

Table 2 provides several perspectives on the credit exposure of the top five derivatives dealers. 

Institutions that do not show significant differences between their current exposures and 

potential future exposures mostly hold short-dated interest rate contracts. 

Table 2: Credit Exposures 

Name

Total 

Derivatives 

($ Billion)

Netted 

Current 

Exposure 

as a 

Percent 

of Tier 1 

Capital

Total 

Gross 

Exposure 

as a 

Percent 

of Total 

Capital

Total 

Netted 

Exposure 

as a 

Percent 

of Total 

Capital

Risk 

Weighted 

Exposure 

as a 

Percent 

of Total 

Capital

Exposure 

Qualifying 

for 

Reduced 

Risk 

Weight

Annualized 

Quarterly 

Chargeoffs as a 

Percent of 

Current 

Exposure

JPMorgan 

Chase 28,020,366 269.7% 654.5% 427.4% 140.6% 54% 0.00%

Bank of 

America 12,467,504 81.8% 203.6% 113.9% 42.1% 43% 0.53%

Citibank 8,381,334 97.4% 201.1% 144.9% 52.4% 45% 0.00%

Wachovia 2,041,244 111.7% 102.4% 102.4% 24.6% 62% 0.23%

Bank One 1,090,634 27.2% 45.4% 35.8% 11.5% 59% 0.26%

Concentrations of credit in banking historically have given rise to significant risk. A concentration 

is a significantly large volume of economically-related financial obligations that an institution has 

advanced or committed to one person, entity, or affiliated group. In order to identify 

concentrations that may be of concern, bank supervisors have used certain benchmarks as a 

starting point. For instance, a concentration of lending to a specific industry like textiles might 

warrant concern when it exceeds a certain percentage of a bank's Tier 1 capital level. 

Derivatives concentration risk is similar in concept to an industry concentration in that the 

counterparties to a dealer have an economic interrelationship through their involvement in a 
derivatives market that is dominated by a few dealers.

Even on a netted basis, several dealers have current credit exposures from derivatives that 

exceed Tier 1 capital. In a stressed market, dealers may suddenly find that seemingly diversified 

counterparties behave similarly.

Recognizing this possibility, however, several factors mitigate the risk. On average, more than 

half of the major dealers' credit exposures qualify for reduced risk weighting under risk based 

capital standards. Most dealer derivative contracts that qualify for reduced risk weighting qualify 

because the counterparty is another depository institution or the contract is secured. Moreover, 

internal reports at several dealers indicate that the average derivatives counterparty rating is 

significantly higher than the average rating of commercial borrowers.

Credit risk is also mitigated if the counterparty is hedging. If the counterparty is hedging with 

derivatives, its unhedged earnings, and therefore its ability to perform under the contract, are 

likely to be higher when the derivatives dealer has the highest credit exposure to it. The value of 

the contract from the dealer's perspective is positively correlated with the hedged aspect of the 

counterparty's business. For example, a company hedging against rising rates would owe the 

dealer money when rates are falling. The counterparty's need to hedge against rising rates 

implies that the company's earnings, apart from the derivatives contract, are improving as rates 

are falling. This relationship suggests that a higher tolerance for concentrations in counterparty 

credit risk may be acceptable than what is accepted in other business lines like commercial 

lending. 

Consistent with the preceding considerations, charged off and past due contracts are negligible 

for derivatives. However, as the Office of the Comptroller of the Currency (OCC) points out in its 

quarterly bank derivatives report, chargeoffs and past dues do not present a comprehensive 

credit performance picture. A more complete assessment of the magnitude of troubled derivative 

exposures would account for restructured derivative contracts, contracts rewritten as loans, and 

those accounted for on a nonaccrual basis in addition to past due contracts. Call Report 

instructions, however, currently require banks to report only past due and charged off derivative 

contracts.

Operational Risk

The largest derivatives losses to date have been because of operational risk. 

Most of the significant losses to date from derivatives activities have arisen from operational 

failures. A review of the largest derivatives losses bears this out. The collapse of Barings Bank in 

1995, Daiwa Bank Ltd.'s loss of its charter also in 1995, and more recent troubles at Allfirst Bank 

in 2002 are just a few examples. In each of these cases, derivatives traders circumvented riskmanagement controls and the institutions suffered significant, sometimes fatal, losses from 

derivatives positions. 

While much of the risk focus regarding derivatives is rightly placed on less well-understood 

derivatives, all else being equal, operational risk increases with the volume of transactions. Each 

derivatives contract must be properly executed and managed throughout the life of the contract. 

The large and rapidly growing derivatives market presents operational challenges for the few 

institutions that are largely responsible for this growth. Operational breakdowns at any major 

dealer could increase its risk profile suddenly and significantly. 

Risk Management and Capitalization of Dealers' Derivatives Activities 

More than 94 percent of bank derivatives activity takes place in the trading portfolios of 
"market risk" banks.

Market Risk

The five major dealer banks set their capital for trading activities using the market risk rule. This 

rule requires certain institutions to set capital for trading assets using internal value-at-risk (VaR) 

models. VaR is a method of assessing risk that uses standard statistical techniques. Essentially, 

VaR is an estimate of a maximum loss that has a low probability of being exceeded over a 

specified time horizon. For example, a bank might estimate that the daily VaR of its trading 

portfolio is $35 million at the 99 percent confidence level. This implies that there is one chance in 

one hundred that, under normal market conditions, a loss greater than $35 million will occur. 

Typically, VaR models use historical market and pricing information to estimate the maximum 

loss that a currently-held trading portfolio is expected to incur at a given confidence level. 

The VaR models used by the derivatives dealers measure the risk of the entire trading portfolio 

of which derivatives trading is only a part. To the extent that these banks are managing the risk 

of their overall trading portfolios well, so they are managing derivatives market risk. The VaR 

models used by market-risk banks, and the capital levels set for market risk are evaluated and 

monitored by the bank's primary federal supervisor. 

Banks are required to supplement VaR analysis with stress testing. While VaR reflects the risk of 

loss due to unlikely events in normal markets, stress testing is designed to estimate a bank's 

exposure to unlikely but plausible events in abnormal markets. Well-defined stress tests that 

translate into risk limits that are enforced within the bank are essential to managing derivatives 

risk. 

The supervisory emphasis for controlling derivatives risk is in the onsite analysis of a bank's 

overall risk management. The primary federal supervisors and the FDIC through its dedicated 

examiner program monitor closely the derivatives activities and risk management systems of the 

major derivatives dealers. 

Credit Risk

With regard to credit risk, banks hold risk-based capital for counterparty credit risk for current 

and potential future exposure. Legally enforceable bilateral netting agreements are recognized 

for current exposure and are assumed to persist when setting capital requirements for potential 

future exposure. Long-dated and volatile contracts require significantly higher capital 

requirements for potential future exposure. 

Operational Risk

Regarding operational risk, implicitly, capital is held for the operational risk of trading activities at 

"market risk" banks by requiring them to hold a multiple of daily VaR in capital. While this 

multiple provides a cushion for non-market and non-credit related risks, the requirement bears 

no empirical relationship to the history of derivatives-related operational losses. Instead, it 

reflects the current state of operational risk modeling practice, which is nascent. Changes under 

Basel II should improve the empirical veracity of the operational risk capital requirements.

Derivatives Activities Receive Significant Supervisory Oversight

Supervisory Strategies Regarding Derivatives Activities

The derivatives activities of the major dealer banks receive significant attention through onsite 

review by the primary supervisors and coordination with the FDIC's dedicated examiner 

program. Current risk-based examination procedures allow for targeted review of areas such as 

derivatives risk, which afford supervisors the opportunity to focus specifically, flexibly, and 

effectively on areas that deserve additional attention. Moreover, oversight and capital 

requirements for derivatives activities are being carefully considered in the Basel II capital 
accord. 

Less Well-Understood Derivatives

Despite the careful oversight of derivatives activities at the major dealers, the activities are highly 

complex as are the models that measure this risk. Errors or omissions in the models of a large 

derivatives dealers could result in significant mismeasurement of exposure to risk. Moreover, 

margins are higher in the less commoditized derivatives activities. Managing the risk of more 

esoteric derivatives, while financially rewarding, is particularly challenging. These derivatives 

may have risks that are vaguely defined, they may have values that are difficult to validate by 

risk management personnel, and may lack the volume of data that is necessary to calculate a 

reliable VaR.9 An institution's risk management group must be given adequate opportunity to 

understand and estimate the risks associated with new or illiquid products before a dealer 

engages significantly in related trading activities. 

The Risks of the Concentration of Derivatives Activity

The concentration of derivatives activities in just a few institutions presents risks that are difficult 

to assess in light of history. The top three derivatives dealers hold 88 percent of total US bank 

derivatives notionals, 89 percent of derivatives contracts that are not interest rate-related, 88 

percent of the apparently unmatched positions, and roughly three quarters of the credit exposure 

depending on how it is measured. Moreover, these companies hold approximately 30 percent of 

the global derivatives market in terms of notional values with just a few international institutions 

filling out most of the remaining market. The consequences of an operational breakdown in one 

these institutions could result not only in significant losses for that institution but could lead to 

liquidity stress in the derivatives market. 

The fact that a majority of bank derivatives activities are in highly liquid markets promotes a 

certain level of comfort despite the large volume of these activities. However, an erosion of 

confidence in one of these dealers triggered by a ratings downgrade or similar event, although it 

is a remote possibility, could result in a rapid change in its risk profile and cause market 

disruptions that challenge even the vast liquidity generally in play in these markets.

Triggers exist in some derivatives contracts that require the dealer to maintain a certain credit 

rating threshold or that may require collateral in certain circumstances. A change in a dealer's 

status could result in counterparties calling in their contracts and taking their derivatives 

business elsewhere. Such an event could result in a significant and rapid change in the 

sensitivities of a derivative dealer's trading portfolio as transactions that were matched previously 

no longer have an offsetting position in the banks trading account. Such a significant change in 

the trading book would necessitate a hasty readjustment of positions in order to address the risk 

of the remaining exposures. If the magnitude of these positions is large enough, the adjustment 

could result in a liquidity crisis cycle that results in a decline in derivative values as the market 

reacts to the dealer's attempt to sell in too great a quantity or too quickly for market liquidity to 

bear.10 If the dealer is unable to rematch positions before the markets move against its 

remaining positions, significant losses could result.

Risk also might be transmitted to other institutions through liquidity stress in the markets that 

disturbs traditional correlations between derivatives and underlying pricing. This effect could 

cause certain hedging strategies to be less effective than originally estimated. The resulting 

market dislocation might also make hedging generally more expensive for a time as derivatives 

holders attempt to replace the contracts that were held previously with the stressed dealer.

Conclusions 

• Most significant derivatives losses to date have occurred because of rogue traders or 

because investment policies were either ignored or not appropriate for the institution 
involved.

• Credit exposure from derivatives amounts to a concentration for several dealer banks; 

but concern is mitigated by the credit quality of the counterparties and the nature of the 

transactions.

• Significant differences in the positive and negative values of derivatives at a few major 

dealers suggest that these banks are managing market risk using risk management 

techniques other than matched trading. Extensive use of other techniques requires a 

high degree of confidence in the reliability of the banks' models, and these techniques 

should be approached particularly cautiously in thinly-traded markets.

• Derivative contract types that are well-understood by risk managers do not pose 

significant risk unless circumstances dictate that a dealer's positions in these contracts 

change more quickly than market liquidity can bear.

• An erosion of confidence in any one of the major dealers could result in a rapid change 

in its risk profile and cause market disruptions because of the influence that any major 

dealer has in the derivatives market.

• Troubles at one major dealer also may transmit to other dealers because of the volume 

of inter-dealer transactions.

• A dislocated market may make hedging more expensive and less effective for a number 

of institutions at least temporarily.

• Extensive dealing in less well-understood derivatives should be pursued only when the 

bank's risk managers develop the ability to reliably quantify the associated risks, even if 

this requires sacrificing higher potential margins in the interim.

References:

Office of the Comptroller of the Currency. OCC Bank Derivatives Report Fourth Quarter 2002. 

Washington, DC.

Bank for International Settlements. November 8, 2002, Press Release and Statistics Guide

Version 1.1 September 2002; Derivatives Market. 

1 The simplified examples in this FYI are for illustrative purposes. They ignore certain subtleties that would attend actual 

transactions.

2 Credit derivatives, which constitute about 1 percent of the total notional amounts are not specifically addressed in this FYI. The 

risks involved in credit derivatives are dissimilar in many ways from the remainder of the derivatives market, and carry many of 

the same risks as direct lending with additional operational risk characteristics. Credit derivatives will be explored in a future FYI.

3 Interest rate contracts could be designed that embed as much risk as exposure to the NASDAQ. However, such a contract 

would be considered highly speculative.

4 Macro hedging refers to the technique of hedging based on a balance sheet position. For example, the would-be hedger 

determines that its earnings or equity value are sensitive to rising short-term rates and constructs an appropriate hedge without 

linking the hedge to a specific asset or liability.

5 These banks are JPMorgan Chase Bank, Bank of America NA, Citibank NA, Wachovia Bank NA, and Bank One NA.

6 The discussion of trading activities has been adapted from the FDIC's Capital Markets Examination Handbook.

7 Speculation and proprietary trading differ only in motive and perhaps size of positions.

8 Open positions are proxied by adding the fair value of derivatives with negative fair values to those with positive fair values for 
the derivatives categories (interest rate contracts, foreign exchange contracts, equity contracts, and commodity and other 

contracts). The absolute value of the position in each category is summed to arrive at a total for each bank.

9 Falkenstein, Eric. "Value-at-Risk and Derivatives Risk." Derivatives Quarterly, Fall 1997. In this article, Falkenstein makes a 

persuasive argument that while much effort is expended on improving the accuracy of VaR calculations for well-understood 

derivatives, the more tangible risks relate to instruments that are not yet well understood.

10 Long-Term Capital Management was involved in a liquidity crisis cycle. Understanding and Monitoring the Liquidity Crisis 

Cycle; Richard Bookstaber; Financial Analysts Journal, Charlottesville; Sep/Oct 2000; Vol. 56, Iss. 5; pg. 17.

ABOUT FYI

FYI is an electronic bulletin summarizing current information about the trends that are driving 

change in the banking industry, plus links to the wide array of other FDIC publications and data 

tools. 

Disclaimer 

The views expressed in FYI are those of the authors and do not necessarily reflect official 

positions of the Federal Deposit Insurance Corporation. Some of the information used in the 

preparation of this publication was obtained from publicly available sources that are considered 

reliable. However, the use of this information does not constitute an endorsement of its accuracy 

by the Federal Deposit Insurance Corporation. 

Last Updated 3/24/2003

Diagram 1

Derivatives Risk Matrix

The diagram is a representation of a graph with a Y and an X axis. On the Y axis are the three 

major derivatives contracts types with the riskiest type at the top. From top to bottom these are the 

following: Equity, Commodity, and Other; Foreign Exchange; and Interest Rate Contracts.

Across the top of the diagram on the X axis are the major derivatives activities as follows: 

Hedging, Dealing, and Speculating. Dealer activities are further broken down into the following: 

match trading , market making, and positioning ( the significance of this breakdown is explained 

further on in the document). In the center of the diagram is an arrow of increasing upward slope 

indicating generally increasing risk. The low point of the arrow is at the intersection of interest rate 

contracts and hedging. The high point of the arrow is at the intersection of equity, commodity, and 

other contracts and speculating. Slightly less than half way up the arrow is a caption indicating 

that 80 percent of bank derivatives activity is a mixture of dealer activities in less risky derivative 

contract types.
Chart 1

The Rapid Growth of Derivatives Is Due 

Mostly to the Growth of Interest Rate Contracts

(Notional Value of Derivatives Held by Banks, $ Billion)

Contracts

Quarter

Interest

Rate

Contracts

Equity, 

Commodity,

and Other

Contracts

Foreign 

Exchange

Contracts

Banks 

Holding

Derivatives

4Q02 48,351 1,009 6,076 5.57%

3Q02 45,695 1,082 6,345 6.06%

2Q02 42,695 1,076 6,313 5.77%

1Q02 39,282 991 5,798 5.61%

4Q01 37,963 950 5,845 5.43%

3Q01 42,880 1,136 6,961 5.35%

2Q01 39,631 1,100 7,131 5.44%

1Q01 35,724 1,096 7,180 5.66%

4Q00 32,966 1,080 6,288 5.69%

3Q00 30,881 1,021 6,471 5.98%

2Q00 30,928 1,018 6,611 5.66%

1Q00 29,699 995 6,406 5.32%

4Q99 27,774 843 5,981 5.58%

3Q99 28,237 807 6,976 5.75%

2Q99 25,734 754 6,803 5.87%

1Q99 25,079 740 7,190 5.85%

4Q98 24,792 684 7,762 5.90%

3Q98 23,847 685 8,763 5.98%

2Q98 20,054 605 8,051 5.88%

1Q98 18,363 528 7,746 5.79%

4Q97 17,087 494 7,746 5.71%

3Q97 17,270 452 7,918 5.83%

2Q97 15,802 413 7,591 5.67%

1Q97 14,562 387 7,387 6.00%

4Q96 13,427 367 6,504 6.38%

3Q96 13,257 351 6,777 6.57%

2Q96 12,517 394 6,685 6.67%

1Q96 11,819 378 6,212 6.96%

4Q95 11,095 378 5,692 6.92%

3Q95 11,330 366 6,546 7.24%

2Q95 11,386 344 6,183 7.14%

1Q95 11,127 349 6,517 6.62%

4Q94 9,925 243 5,605 6.56%

3Q94 9,546 261 5,961 6.53%
2Q94 9,048 236 6,038 6.64%

1Q94 8,329 201 5,387 6.68%

4Q93 7,215 179 4,484 6.51%

3Q93 7,008 190 4,791 6.06%

2Q93 6,316 137 4,496 5.84%

1Q93 5,460 119 4,191 5.92%

4Q92 4,873 102 3,789 5.67%

3Q92 5,051 109 4,555 5.80%

2Q92 4,421 105 3,888 5.75%

1Q92 4,182 109 3,799 5.76%

4Q91 3,837 109 3,394 5.48%

3Q91 3,560 91 3,459 5.38%

2Q91 3,248 86 3,577 5.33%

1Q91 3,301 83 3,683 5.21%

4Q90 3,311 82 3,413 5.18%

3Q90 3,308 79 3,620 5.30%

2Q90 2,963 60 3,491 5.17%

1Q90 2,754 51 3,388 5.07%

Source: FDIC Research Information System