Trading Counterparties, Systemic Risk & Investment Bank Collapses

The weekend edition of the Wall Street Journal contained an article bemoaning the lack of a centralized exchange for various derivative and swap transactions, in the wake of March's crisis involving Bear Stearns, and the current worries over Lehman's solvency.

What strikes me as odd is how apparently fragile and susceptible to counterparty risk our financial system is, a full ten years after the LTCM meltdown.

I notice that, although 'investment banks' are involved in recent troubles, it's always their trading desks which are the cause, through the use of over-the-counter, or non-exchanged cleared instruments.

It gives me great pause to wonder how we can continue to let our financial system appear to be hostage to one mid-sized trading operation failing to make good on its obligations?

Isn't the current environment one in which each trading operation is expected to manage the risk of its counterparties? Why should the Federal government have to intercede for so many questionable positions?

Perhaps what we should acknowledge is that, when instruments are traded without an exchange which requires deposits for positions, the entire system is liable to the degree of the worst party's risk management practices.

If one trading house exercises sloppy, inadequate risk management, and thereby loses money due to a counterparty's failure to perform, and, thus, sets off a chain reaction, then even the best-run, risk-managed party is at risk.

I suppose that, over the past 10-20 years, trading volumes ballooned in off-exchange instruments, and trading function managers, as so many financial executives, have not seriously considered the systemic component of counterparty risk in their derivatives and swaps positions.

Perhaps the lack of a serious default of a counterparty has blinded the risk-allocation and -assessment models used by many trading houses to the actual losses which would occur in that event.

This is quite troubling to me, because common sense would have you expect that Lehman's demise should not cause all that much loss. By now, one would hope that either writedowns are taken on the positions, by the counterparties, or collateral increases are required.

Why should the mere bankruptcy of Lehman cause such concern in the financial community, if it is composed of competent traders, trading and risk managers? Are we in such short supply of competent financial service executives that this is really an issue?

I don't recall this sort of concern when Drexel Burnham Lambert was pushed into dissolution. Why is it so different, and more urgent, now?

Have non-exchange trading markets really grown so large and risky that any counterparty's demise will cause a systemic disaster?