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I have been extremely interested in the global derivatives market ever since I saw the documentary "Collapse." I am not going to bore you with the details of this documentary, but to summarize, the documentary focuses on the unsustainable global dependence on oil supply (which is decreasing), and the unsustainable nature of our current capitalistic society (topic for another day). In this documentary the main character/pundit/whistleblower, Michael Ruppert, states that the world derivatives market is in excess of $700 trillion. Needless to say I was blown away by this amount, and I vowed to do some research and figure out how there can be an active financial market 50 times that of the United States Gross Domestic Product. I am not going to attempt to delve into the global derivatives market as a whole. Instead, I will focus on the derivatives that are written by U.S. commercial banks, talk about the various derivatives out there, and explain the amount of exposure to the United States banking system. To do this I will be using the most recent OCC report on derivatives held by commercial banks here in the U.S.

Summary of the U.S. Derivatives Market

  • U.S. commercial banks currently hold a notional value of $244 trillion in derivatives.
  • Trading exposure, which is measured by VaR (Value at Risk), is $677 million.
  • Net Current Credit Exposure of commercial banks to derivatives is $353 billion, due to bilateral netting.
  • Potential Future Exposure is $814 billion, bringing Total Credit Exposure (NCCE + PFE) to $1.2 trillion.
  • The total amount of Credit Derivatives outstanding is $14.9 trillion.
  • 30 days or more past due derivatives equaled $42 million, and $74 million in derivatives was charged off this quarter.
  • 59% of counterparties are banks and securities firms, 35% are corporations, 1% are monoline financial firms, 2% are hedge funds, and 3% are sovereign funds.
  • Banks hold collateral equal to 72% of Net Current Credit Exposure.
  • 82% of derivatives are interest rate products, 10.9% in FX contracts, 6.1% in credit derivatives, and .6% are in commodities and equity contracts, respectively.
  • Five banks dominate the U.S. derivatives market, J.P. Morgan Chase (JPM), Bank of America (BAC), Citigroup (C), Goldman Sachs (GS), and HSBC (HBC), accounting for 96% of the derivatives activity. However, a total of 1,047 U.S. banks participated in the derivatives market in the first quarter.
  • Banks reported trading revenue (revenue pertaining to derivatives) of $7.4 billion in the first quarter of 2011.

This is a lot of information to handle so I am going to delve deeper into all of the summary points, and shed some light on all of these statements.

U.S. commercial banks currently hold a notional value of $244 trillion in derivatives.

Notional value is the face amount of the derivative used to calculate payment on swaps, options, futures, and forward contracts. This is not the amount of exposure that banks have to the derivatives market. Here is a simple example: Two parties approach a bank, and they want to do an interest rate swap for a loan. One wants a fixed interest rate, while the other wants a floating interest rate. The bank acts as a clearinghouse and third party overseer for this transaction. Both parties pay a set fee (usually a spread on the interest rates) to the bank based on the amount of the loan amount they are swapping payments on, they also give their respective payments on the loan amount through the bank, and the bank sends the payment to the other party. Now if the amount of the loan that the two parties were swapping interest rates on was $1 trillion that $1 trillion would be included in the notional value of derivatives held by the banks. Another example: If a bank buys or sells (hedges risk or assumes risk) a Credit Default Swap the face amount is included in the notional value.

Trading exposure, which is measured by VaR (Value at Risk), is $677 million.

VaR (value at risk) is a statistical analysis performed by banks to determine the potential amount of maximum expected losses (on their trading activities) that they could sustain over a specified duration of time and under normal market conditions. Here is an example from the OCC report.

A VaR of $50 million at 99% confidence measured over one trading day, for example, indicates that a trading loss of greater than $50 million in the next day on that portfolio should occur only once in every 100 trading days under normal market condition.

Basically, the VaR is telling us that the bank is 99% confident (confidence level depends on the standard deviation used) that over the next 100 trading days it will lose a maximum of $50 million. So the total VaR of $677 million for the quarter is the maximum expected aggregate loss that banks think they could lose.

Net Current Credit Exposure of U.S. commercial banks is $353 billion, due to bilateral netting.

How can notional derivatives equal $244 trillion and the banks only be exposed to $353 billion in potential losses? There is a common misconception that the credit risk experienced in the derivatives market is the same as the credit risk experienced in the loan market. The credit risk in the regular loan market is the face amount of the loan given to the borrower, the exposure is unilateral. The credit risk in derivatives is different due to the fact that there are two parties to the vast majority of derivatives contracts. The bank enters into a legally binding contract with counterparties called bilateral netting. This contract states that if one of the parties defaults, the remaining balance of the contract would be the net sum of all positive and negative fair values of contracts included in the bilateral netting arrangement.

How does the OCC calculate Net Current Credit Exposure?

They start by looking at the fair value amount that is owed to the banks this amount is called derivatives receivable or Gross Positive Fair Value (this does not take into account collateral held by banks). This is the amount that the banks would be in the hole if all of their counterparties defaulted. They then look at the fair value amount that the banks owe to their counterparties, this amount is called derivatives payable or Gross Negative Fair Value (this amount does not take into account collateral held by the counterparties.) This is the amount that the banks' counterparties would lose if the banks' defaulted. The OCC then subtracts the amount at risk (Gross Positive Fair Value) from the amount owed to the counterparties and that is the Net Current Credit Exposure.

Potential Future Exposure is $814 billion, bringing Total Credit Exposure (NCCE + PFE) to $1.2 trillion.

Essentially, Potential Future Exposure is an amount calculated at a certain confidence level (much like VaR), for the remaining life of the contract. The $814 billion is the maximum potential exposure banks could face for the life of all their derivatives contracts. Potential Future Exposure takes into account future increases in value of the derivatives receivable. The $814 billion is a future increase in value of the receivables owed to the banks increases their total credit exposure. An increase in value can be attributed to any number of reasons from a change in foreign exchange rates to a rising or falling of interest rates. Here is a somewhat outdated (2002), but great explanation.

The Total Amount of Credit Derivatives Outstanding is $14.9 trillion.

The vast majority (97%) of credit derivatives are Credit Default Swaps. The $14.9 trillion is just a notional amount however. As of this quarter, banks assumed risk (wrote credit derivatives) in the amount of $7.4 trillion, and hedged risk (bought credit derivatives) in the amount of $7.5 trillion. Due to the fact that 43% of the notional amount of derivatives is sub- investment grade, the banks are obviously betting that certain parties are going to default, and they are hoping to make some trading revenue on their credit derivatives.

30 Days or More Past Due Derivatives Equaled $42 million, and Banks Charged Off $74 Million in Derivatives Contracts This Quarter.

This is exactly how it reads. Out of a notional value of $244 trillion banks had to charge off a mere $74 million. Granted, during the financial crisis that amount was $847 million in the fourth quarter of 2008, but needless to say things have vastly improved since then.

59% of counterparties are banks and securities firms, 35% are corporations, 1% are monoline financial firms, 2% are hedge funds, and 3% are sovereign funds.

No need to elaborate here, except to say that this illustrates why there are the terms TBTF and contagion. The game dominoes really comes to mind at this moment.

Banks Hold Collateral Equal to 72% of Net Current Credit Exposure.

88% of this collateral is cash and treasury securities (very liquid assets). Depending on the counterparty banks like hold a certain percentage of collateral. 93% collateral was held against the NCCE to banks and securities firms, 302% against hedge funds' NCCE, 5% against sovereign governments' NCCE, and 36% against corporations'.

82% of derivatives are interest rate products, 10.9% in FX contracts, 6.1% in credit derivatives, and .6% are in commodities and equity contracts, respectively.

These products can be broken down into five different types of derivatives: Futures, Forwards, Swaps, Options, and Credit Derivatives. Needless to say these are very complex financial products that are hard to understand, but I will do my best to explain them for you.

Swaps - are used exactly as their name suggests, to swap (exchange) cash flows at a certain date. These types of derivatives are used mainly for interest rate swaps, but can be used to swap cash flows from equities, commodities, or foreign currency.

Futures & Forwards - I am going to lump these two together because they are similar, but not the same. Engaging in a forward requires you to buy/sell a certain equity/commodity/foreign currency at a set price at a set point in time. Engaging in a future is almost the same agreement as a forward but, your position is usually opened on margin, and is traded marked to market, and you can close your position out at any time.

Credit Derivatives - Basically an assumption or a hedging of risk on any kind of asset, or liability.

Options - Gives the owner the right to buy/sell the underlying security before or on the expiration date at a certain price.

Five banks dominate the U.S. derivatives market, J.P. Morgan Chase, Bank of America, Citigroup, Goldman Sachs, and HSBC, accounting for 96% of the derivatives activity. However, a total of 1,047 U.S. banks participated in the derivatives market in the first quarter.

The amount in notional derivatives written by the five biggest banks from highest to lowest goes in this order J.P. Morgan Chase, Citigroup, Bank of America, Goldman Sachs, and HSBC.

Conclusion:

While the $244 trillion notional derivative market looks menacing on paper, once you break it down, it isn't as scary as it looks. The banks have collateral on the majority of their Net Current Credit Exposure, and the economy (for all its current faults) is getting better. In my opinion, the derivatives market is an essential tool for traders, hedge funds, companies, and banks to hedge risks and reap rewards. There is no possible way that this market is just going to disappear overnight. I think that $99 billion (when you subtract collateral) in NCCE is acceptable, when you consider the benefits that the derivatives market gives the global economy.

Source: America's Big Bank $244 Trillion Derivatives Market Exposed