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.