Why Derivatives May Be the Biggest Risk for the Global Economy

Since the recession, the value of derivatives outstanding has grown, and they remain very risky with the potential for large, unpredictable losses.

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Four years after the U.S. recession ended, the global economy is still beset by problems. The present danger comes from Cyprus – where the sea foam once gave birth to the goddess Aphrodite but now only creates froth in panicky financial markets. The proposed bailout plan for troubled Cypriot banks would impose losses of up to 40% on the largest depositors. And that, in turn, could undermine confidence in the banks of other troubled euro zone countries.

Cyprus is only the latest challenge for global financial stability, however. In the U.S., deteriorating urban finances – from Detroit to Stockton, Calif. – threaten municipal bond holders, public-sector workers, and taxpayers. In addition, a rise in long-term interest rates seems inevitable sooner or later, either because of inflation or because the Federal Reserve backs away from its easy-money policies. Higher interest rates would mean big losses for bond investors, and also for government-sponsored entities, such as Fannie Mae and Freddie Mac, that hold mortgage-backed assets.

The greatest risk of all, however, may be one of the least visible – namely, the expanding, shadowy market for derivatives. These highly sophisticated investments have contributed to financial disasters from the 2008 bankruptcy of Lehman Brothers to J.P. Morgan’s 2012 trading losses in London, which totaled more than $6 billion.

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Basically, derivatives are financial contracts with values that are derived from the behavior of something else – interest rates, stock indexes, mortgages, commodities, or even the weather. Just as homebuyers make only a down payment when they buy a house with a mortgage, derivatives traders put down only a small amount of cash. Moreover, one derivative can be used to offset or serve as collateral for another. The result is that a massive edifice of derivatives can be supported by a relatively small amount of real money.

Some derivatives, such as typical stock options, trade on exchanges. But many are simply private contracts between banks or other sophisticated investors. As a result, it’s hard to know the total volume of derivatives now outstanding. The worldwide nominal value – also known as the notional or “face” value – of derivatives tripled in the five years leading up to the recession, at which time it was around $600 trillion, according to the Bank for International Settlements. Since then, although some specific categories of derivatives have shrunk, the total value of the derivatives market has not been reduced at all, but has actually gotten bigger.

Although recent BIS data shows only a little growth in the overall value of derivatives, some leading bond portfolio managers and derivatives experts believe that the market has continued to expand rapidly, without being especially visible. While there’s no way of knowing for sure, estimates of the face value of all derivatives outstanding tops a quadrillion (1,000 trillion) dollars, or more than 14 times the entire world’s annual GDP. By comparison, the total value of all the stocks trading on the New York Stock Exchange is roughly $15 trillion. Indeed, the New York Stock Exchange itself is being acquired by an up-and-coming derivatives exchange.

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The very fact that reliable figures are hard to come by is itself part of the problem. The $638 trillion currently reported by the BIS is only a floor. Estimates for the total capital employed in derivatives trading is somewhere between $10 and $20 trillion, roughly comparable to the capitalization of the NYSE. That means that each actual dollar in the derivatives market is supporting between $35 and $70 of nominal value. Losses of only a few percent of face value therefore would be enough to wipe out even the best-capitalized derivatives traders.

The problems don’t stop there. Not only is the bulk of the market private and hard to track, but it still isn’t properly regulated. Although the Volcker Rule limits the speculative trading that commercial banks can do, it isn’t as rigorous as the actual separation of commercial lending and investment banking that existed under the Glass-Steagall regulatory framework that was in place from 1933 through most of the 20th century. Other recent regulation aims for more transparency and greater capital requirements. But progress is slow, both in the U.S. and in Europe. And regulators acknowledge that the job is far from done.

One key problem is what’s known as counterparty risk. If you buy a stock for cash, you can’t lose more than you invest. But if you sell $1,000 of derivatives and collateralize it by purchasing $900 of another offsetting derivative, how much are you really at risk? In theory, you can only lose $100. But if the person from whom you purchased the $900 derivative ends up defaulting, then you’re on the hook for all $1,000 you sold. So are you at risk for $100 or $1,000? It’s hard to know. Regulators try to assign weights and probabilities to determine capital requirements. But the bottom line is simple: If the whole market comes apart, everyone is at risk for a lot more than they expect.

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With Cyprus, or municipal finances or even the bond market, it’s possible to count the amount of money involved and gauge the scale of possible losses. By contrast, the derivatives markets are impossible to measure with any confidence. All that we can know for sure is that they weren’t reined in and didn’t get any smaller after the last financial crisis. It’s difficult to assess the actual risk exposure of any given set of trades, and equally hard to determine the amount of capital needed to be safe. Overall, the markets are extremely leveraged, which means that any miscalculations could have a domino effect. And in theory, at least, the total losses could add up to more money than there is in the entire world.

6 comments
deberube
deberube like.author.displayName like.author.displayName 2 Like

Swax111,

Sorry, your analysis does not stand up under light scrutiny. The most dangerous forms of derivatives such as CDS, CDO's, etc... are the main cause of the 2008 crash and the current worldwide depression, this is not questioned. To say that the average person should have hedged they're retirement accounts for protection from other derivatives is mad.

Sovereign debt is attacked by high finance types with CDS in order to essentially loot those countries and cause them to go under the control of the IMF. 

The idea that reducing the deficit helps is not credible. It may be repeated often, but it holds no weight. There are simply no examples of austerity successes. On the other hand, look at UK, Greece, Germany (1920's-1933)  and countless other examples of how austerity makes the problem worse. Picking on entitlements as you say, is a typical rabid banker response when questioned about how to go about fixing things. Again, this is nonsense. When you take away productive investment and replace it with speculative gambling (caused by "free-trade", repeal of Glass-Stegall, general deregulation) you reduce employment and cause a greater need for entitlements. But the Federal Reserve would rather give  $20+ trillion to banks that control it to pretend they are not broke as opposed to building needed infrastructure to stop the depression. 


And yes there can be (and by most estimates, is) more debt than there is actual money when using derivatives. The fact that you do not understand this makes your entire analysis questionable. Derivatives are not properly accounted for by any means, that is why we do not actually know the amount of debt out there. 

The financial world is in a psychosis of denial and confusion about what they have done.  Their only response is "De-regulate even more and cut all non-military spending". Here is a solution, a 1% Wall St sales tax on derivatives, ban the most dangerous ones. Go back to Glass-Stegall which worked fine from 1930's-2000. Force the federal reserve to buy 0% bonds for massive infrastructure projects such as high speed rail plus the $3.6 trillion that America's engineers recommend to maintain are way of life. http://www.infrastructurereportcard.org/ 




swax111
swax111 like.author.displayName like.author.displayName 2 Like

Hmm - saw this in a financial Twitter feed and could not help myself... A lot of misinformation in here. As per usual, articles from folks like Time and USA Today usually don't have an experienced enough readership to ascertain the lack of depth in your argument that there are essentially 'too many' derivatives or too much risk.

Let's take retail stock options, something the average middle American could use. If middle class stock owning Americans (approx 20% of stock owners) had all been hedged by writing covered calls on their IRA during 2007-2008, they would all be a lot richer. Or had they bought some simple put protection. Instead, most of them don't know what options are - and are too lazy to read about them. So, taking it from a simple stand point, derivatives could have helped a lot of people from losing their retirement money - but people don't understand them.

The truth is the derivatives market is why major disasters *don't* destroy certain insitutions. This is why CDSs are so important. Had Cyprus banks been better hedged, instead of assuming that European, specifically Greek debt, was relatively safe - then they would not be as crippled and Cyprus would not be dipping into deposits. 

Also - your comment  "And in theory, at least, the total losses could add up to more money than there is in the entire world"... NO NO. :) Sorry - that is not how derivatives work, or how they are handled in accounting. Just because a dervatives is currently worth more than purchased, or in-the-money (for retail people) does not mean it's paper value is greater. This is just not how they are  accounted for. Also, "Losses of only a few percent of face value therefore would be enough to wipe out even the best-capitalized derivatives traders." No, not for most well capitalized traders, because they are not stupid enough to make one-way bets. But there will always be your outliers, nutty hedge funds, and people like Corzine. I do agree however that these markets need much greater transparency - absolutely.

The main reason derivatives have a bad name right now, is that the *most* *supposedly* secure financial instrument, sovreign debt, is being question for its risk-off nature. This is causing run ups in rates across all of europe, changing coupon prices, and igniting CDS (credit default swap) contracts, some of which can't even be paid off. If you want to pick on something, pick on irresponsibly run entitlement countries in southern Europe. And even pick a little on big ones like us in the States for not passing budgets which reduce deficits.  ...but derivatives are not the core problem. 

Hopefully one of the Time readers will actually do some research after reading this.

llovelymummy
llovelymummy

@swax111 I have tried to do research, it is all too complicated for me, and I suspect for many elderly. Also there are so many opposing standpoints and views it is a mind boggling task to see the wood for the trees.

Anyone ever thought of publishing a Glossary/Book, or know of a book for beginners please?

DaveGreen
DaveGreen

What kind of shenanigans are going on out there in the world of "high finance". How have we allowed derivatives to pile up such ridiculous amounts of risk?? More money than exists in the entire world?  Get real!