Market for derivativescontracts for the first time ever

Bloomberg

The amount of outstanding contracts linked to bonds, currencies, commodities, stocks and interest rates fell 13.4 percent to $592 trillion, the Basel, Switzerland-based bank said on Monday. That’s the first decline in 10 years of compiling the data.

The amount of credit-default swaps protecting investors against losses on bonds and loans fell 27 percent to cover a notional $41.9 trillion of debt.

Investors shunned derivatives as demand for risky assets withered after the collapse of Lehman Brothers Holdings in September.

The credit derivatives market also contracted as traders canceled redundant default swaps to appease regulators and help reduce day-to-day payments and the potential for error.

"Severely strained credit markets combined with efforts to improve multilateral netting of offsetting contracts" helped cut notional volumes, BIS analysts Jacob Gyntelberg and Carlos Mallo wrote in the report.

Protecting corporate debt

The cost of protecting corporate debt against default doubled in the second half of 2008, according to the Markit ITraxx Europe Crossover index of credit-default swaps linked to high-risk, high-yield companies. The increase boosted the amount of money at stake in the contracts to $5.7 trillion from $3.2 trillion in the first half of last year, according to the BIS.

The U.S. administration announced proposals last week to expand regulation of derivatives, which have been blamed for contributing to the failures of Lehman Brothers and American International Group, leading to the seizure of credit markets and causing more than $1.4 trillion in losses and writedowns by financial companies.

If changes are not made "we will be haunted by our failure for years to come," Brooksley Born, the former U.S. official who lost the fight to regulate derivatives a decade ago, said on Monday.

The data compiled by the BIS are based on contracts traded outside of exchanges in the over-the-counter market. Interest-rate derivatives remained the largest part of the market, falling 8.6 percent in the second half of 2008 to $418.7 trillion outstanding, the report said.

Foreign exchange contracts fell by 20 percent to $49.8 trillion. The amount of equity derivatives declined 36 percent to $6.5 trillion and those linked to commodities contracted by 67 percent to $4.4 trillion.

Derivatives are financial instruments derived from stocks, bonds, loans, currencies and commodities, or linked to specific events like changes in interest rates or the weather.

Credit-default swaps pay the buyer face value in exchange for the underlying securities or the cash equivalent should a company fail to adhere to its debt agreements.