The $54trillion credit derivatives market faces a delicate test as $360bn worth of contracts on now-defaulted derivatives on Lehman Brothers are due to be settled on Tuesday.
Lehman Brothers’ complex network of derivatives will be settled on Tuesday October 22
Due to the opacity of the market, which is one of the most complex, least regulated and least understood in the global financial system, it is still not clear how many contracts have to be settled or which institutions will take the ultimate hits once the billions of dollars worth of contracts have been unravelled.
The collapse of Lehman Brothers, is expected to trigger credit default swap (CDS) protection pay-outs of about $400bn but because the contracts were sold many times through different counterparties it is not yet known who will be liable.
One commentator said: “This will be the greatest illustration of the follies of Wall Street and how unnecessarily complicated the wild off-track betting became in the past few years.”
Five years ago Warren Buffett, the iconic American investor, warned that the chaotic profusion of derivatives used by companies and hedge funds to fund financial growth were “financial weapons of mass destruction.”
Bankers in the City and on Wall Street are bracing for yet another round of turbulence as the contracts are unwound.