The Derivatives Myth

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Includes: BAC, C, GS, JPM, MS
by: Paulo Santos

One of the things most often cited in doomsayer circles, is how Bank of America (NYSE:BAC), Citigroup (NYSE:C), Goldman Sachs (NYSE:GS), JPMorgan Chase (NYSE:JPM), and Morgan Stanley (NYSE:MS) have, between themselves, a gigantic derivative exposure amounting to several times the World GDP.

This seems like a solid criticism, because you can actually quote ISDA on it:

The total combined notional amount outstanding of interest rate, credit, and equity derivatives at June 30, 2010 was $466.8 trillion, an increase of less than 1 percent from the end of 2009. Of the total notional amount, the fourteen largest global derivatives dealers, known as the G14 group, reported $354.6 trillion or 82 percent. And the five largest US-based dealers reported a notional amount outstanding of $172.3 trillion, or 37 percent of the total. A total of seventy-one ISDA Primary Member firms participated in the Mid-Year 2010 Survey.

The problem with this criticism, however, is that it’s simply a myth. It rises from the fact that people do not know how these numbers come about. The purpose of this article will be to show why it is a myth.

First, imagine you were trading futures. You bought 10 ES (S&P500 mini-futures) in the market (against God knows who), and you sold them back a bit later (against someone else). How many ES would you be exposed to at this point? A big, round zero, right? Now, the problem is that in the OTC (over-the-counter) derivatives market, in the statistics shown above, this would actually report you holding 20 ES futures. And the more you traded, the more it would show you holding. See the issue?

The problem arises from the fact that we’re talking OTC derivatives with no central clearing, so the contracts don’t cancel themselves! They mostly add up, unless you do the opposite trade with EXACTLY the same counterparty! Knowing this, the incredible explosion in derivative exposure does not seem so incredible anymore, especially taking into account that those banks make a market on these derivatives, does it?

Yet, nobody ceases to mention how these banks hold this amazingly large derivative exposure, which obviously they don’t! And this myth lives on, even though there is proof of it being bogus. For instance, regarding the Lehman Brothers bankruptcy (source: Wikipedia):

It was also reported after Lehman's bankruptcy that the $400 billion notional of CDS protection which had been written on the bank could lead to a net payout of $366 billion from protection sellers to buyers (given the cash-settlement auction settled at a final price of 8.625%) and that these large payouts could lead to further bankruptcies of firms without enough cash to settle their contracts. However, industry estimates after the auction suggested that net cashflows would only be in the region of $7 billion.

This is not to say that the (large) derivatives exposure does not have any meaning. It does have a meaning – it’s an estimate of the total counterparty risk. But even that does not take into account how many of those derivatives are actually written/bought exactly to mitigate such risk. They’re all just added up, unless they are canceled with the precise same counterparty!

Conclusion

There might be many reasons to sell at least some of the banks, chief amongst them that Citigroup and Bank of America still have huge market caps when compared to JP Morgan, but the supposed mega-catastrophe of the huge derivative exposure is not one of them.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.