Occasionally, central bankers reveal their deepest darkest fears. That fear has a name - derivatives. Although not a central banker, Warren Buffet famously articulated the problem:
"I view derivatives as time bombs, both for the parties that deal in them and the economic system. The derivatives genie is now well out of the bottle, and these instruments will almost certainly multiply in variety and number until some event makes their toxicity clear. In my view, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal"
He said that back in 2002, when according to the BIS, the end-of-year notional value of derivative contracts were valued at $142 trillion.
That number is so large that is defies comprehension. In 2002, US nominal GDP was $10.5 trillion. So at the time that Buffet gave his dire warning, the notional value of outstanding derivatives was 13.5 times US GDP.
I don't have the 2002 number for world GDP with me at the moment, I am going to take a rough guess and say that the US economy accounts for approximately 20 percent of the total. If this is so, then back in 2002, derivative contracts were equivalent to 2.5 times world GDP.
Here is the shocker; since 2002 the derivatives market has exploded. Financial markets didn't listen to the Buffet warning. At the end of last year, the number stood at $600 trillion.
This represents 43 times US GDP and about 9 times world GDP. Given that the world population is roughly 6 billion people, there are derivatives contracts amounting to $99,000 for every person on this debt ridden, hopeless and forsaken planet
If that wasn't shocking enough, over the last 10 years, the market has grown 600 percent. Last year alone, the number grew 43 percent.
These numbers are so huge that they make no sense whatsoever. I am almost inclined to say that the BIS accidentally added a few zeros. Perhaps they meant millions and not billions. Maybe the BIS don't understand what they are counting. Possibly they are double counting. Whatever it is, the numbers on derivatives are literally off the planet.
The alternative is just too appalling to contemplate; that a few hundred banks around the world have been creating all kinds of new ways to gamble. After all, that is the essence of a derivative. It is punt just like a bet on the gigis down at Labrokes. Could it be that like all inveterate gamblers, banks kept increasing the stakes and now they have more money on the table than the total size of world GDP?
I heard someone say recently that financial markets have gone mad. I thought that the claim was a little excessive until I looked at the data on derivatives.