Monday, 22 September 2008

What does it mean?

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.


sobers said...

What worries me about the derivatives market is this:
Each trade has two partners - the writer and the purchaser. One loses money, one gains money on its expiry. The amount is variable but possible unlimited either way. Most investment companies will have trades that cancel each other out so 'technically' their liability is close to zero.
However, if somewhere along the line someone goes bust and can't pay out when their 'bet' goes tits up, will this not have a chain reaction throughout the system? People who were expecting to be paid on a certain outcome (gold going up, or oil down for example) lose those payments, but are still liable for payments to others in the matching trades. They default as well. The whole house of cards falls before our eyes.
Could that be what the Fed feared with the Bear Stearns and AIG cases? But not in Lehman's for some reason?

mike said...

To protect against such madness the solution is simple. Don't trade in US dollars, don't setup business in the US and don't rely on US made trade products to run your business.

It won't be long before crooks are able to bring down the US financial system to its knees. It's scary to think the US government might default on it's own debts. Some people are already betting on it:

What a stupid financial system!

aSteve said...

Erm, OTC derivative contracts can be established in any currency, or for any foreign exchange, or for any interest rate, or for any default. These are not limited to being American - London has been the centre for derivative trading in recent years.

The consequence of derivatives is two-fold. On one hand it dramatically complicates the liquidation of insolvent organisations - but it does not make this impossible. Those regulated by the FSA, for example, will be propped up until their derivative contracts can be unwound... it is bureaucratic and expensive and time consuming - but no Armageddon in itself. Frankly, I don't care if reckless banks are liquidated (as long as depositors' cash is preserved.)

A far, far worse situation arises with the implication for perception of risk. Where the derivative contracts appear to allow risk to be hedged - and for massive leveraged profits... there is a danger that the real risks of economic activity will be overlooked... and our financial system one might think of as an essential assistance to a free-market economy becomes its nemesis... where finance is not available for ventures to generate wealth - only to prop up usury and to exacerbate poverty on a global scale.

Where opaque contracts are used to present the illusion of risk-free profit, one can be certain that this will have a negative impact on tangible economic progress - and that this, in turn, may cause feedback and a spiralling depression.

I think OTC derivatives are dangerous - but not in the obvious way. I think they are dangerous as they complicate business analysis and appears to reward gamblers over the prudent. I expect, for example, the presence of CDS contracts to mean that there are a lot more defaults... since many demographics have been desensitised to the consequences of default - making solvency harder to pursue.

dearieme said...

"many demographics have been desensitised to the consequences of default ": what do you mean by that, asteve?

Anonymous said...

And remember 1 in 6 people on this planet live on less than a dollar per day - chances of getting $99,000 out of them..?

Anonymous said...

The below is a good article. Cheers, David

Ellen Brown, September 18, 2008
“I can calculate the movement of the stars, but not the madness of men.”
– Sir Isaac Newton, after losing a fortune in the South Sea bubble

aSteve said...

"many demographics have been desensitised to the consequences of default ": what do you mean by that, asteve?

Erm, just what I said... maybe I should expand?

Desensitisation has occurred on every level... most retail: the spendthrift who has kited debt between credit cards for years - lulled into a false sense of security that another good deal will arrive when the present one expires. On the other side of the fence, the ability to "hedge" default risk allowed lenders to, essentially, ignore creditworthiness of borrowers... writing CDS contracts became seen as "free money" and there was great competition - driving down prices to unsustainable levels which all but guaranteed a global credit crisis on a systemic level.

There's a psychological angle, see... when it is your money (i.e. non-leveraged investment) at stake, investors tend to be sensibly cautious... when the trades that define prices are trades on margin, the mob looses sight of fair value and risk. This was clearly demonstrated by the 1929 stock market crash - which is widely attributed to people over-stretching buying shares on margin. While it can make a lot of sense for one person to buy shares on margin - it is ridiculous, however, for a lot of people to do it. Similarly, with CDS (default insurance for banks) it might make sense if used sparingly... but where the market for CDS dwarfs world capital - alarm bells should be ringing loudly. It only requires a small error of judgement on each contract for there to be spectacular consequences.

Anonymous said...

I think of the CDS market as being like the bookies at the racetrack. People winning fortunes then losing their shirts off-track shouldn't affect the performance of the horses (companies) their jockeys (managers), their prize money (profits) or the share of the profits returned (dividends) to the owners (shareholders).

Or so we'd hope. But once the jockeys start using their horses as collateral to bet on the race positions of rivals. Watch out.