Who Owns the Derivatives Market?

Includes: BAC, C, JPM
by: Mark Sunshine

The entire debate about the regulation of derivatives contracts takes on a new meaning in light of the OCC’s Quarterly Report on Bank Trading and Derivatives Activities, Second Quarter 2009. The OCC (Office of the Comptroller of the Currency) publishes all sorts of interesting reports and handbooks that are largely overlooked by the media. And, the Derivatives Report is one of those OCC reports that almost no one seems to look at or care about.

For those readers who don’t know what a derivative is, Wikipedia has a great definition:

A derivative is a financial instrument that is derived from some other asset, index, event, value or conditions (known as the underlying asset). Rather than trade or exchange the underlying asset itself, derivatives traders enter into an agreement to exchange cash or assets over time based upon the underlying asset.

Some derivatives are garden variety exchange traded contracts that have an undisputed legitimate place in global finance. Stock futures like puts and calls are examples of exchange traded derivative contracts that aren’t particularly controversial. Interest rate swaps (contracts that banks, investors, corporations and individuals use to hedge movements in interest rates) are another example of derivative contracts that have a long established legitimate role in the global economy. The same can be said for most contracts to hedge movements in currency exchange rates.

However, there are other types of derivatives contracts, such as credit default swaps, that Warren Buffett has called “financial weapons of mass destruction” and which many economists and commentators, myself included, think have a very limited role to play in legitimate business. The trading of naked credit default swaps and commodity futures contracts that aren’t attached to an actual underlying delivery of a commodity are considered some of the “games of choice” for the U.S. casino society.

But if the U.S. has turned into a casino society, who owns the casino and how much is the casino making for its bosses?

As it turns out, the OCC Quarterly Report answers my question.

From the OCC Quarterly Report:

The notional value of derivatives held by U.S. commercial banks increased $1.5 trillion in the second quarter, or 0.7%, to $203.5 trillion.

U.S. commercial banks reported revenues of $5.2 billion trading cash and derivative instruments in the second quarter of 2009, compared to a record $9.8 billion in the first quarter.

A total of 1,110 insured U.S. commercial banks reported derivatives activities at the end of the second quarter, an increase of 47 banks from the prior quarter. Nonetheless, most derivatives activity in the U.S. banking system continues to be dominated by a small group of large financial institutions. Five large commercial banks represent 97% of the total banking industry notional amounts and 88% of industry net current credit exposure (emphasis added).

Banks reported trading revenues of $5.2 billion in the second quarter, down 47% from the record $9.8 billion in the first quarter. Notwithstanding the large drop in trading revenues, the second quarter performance was still the sixth highest revenue quarter for commercial banks.

The OCC Quarterly Report goes on to state that derivative contracts are concentrated in interest rate products which make up 85% of the notional value of all derivative contracts. On the other hand, credit default swaps only make up about 15% of the gross notional amount of derivatives contracts written by banks.

But, despite the relatively small size of credit default swaps they accounted for approximately 37% of the trading revenue of all derivatives contracts. Interest rate swaps, despite being a much larger in size, accounted for only approximately 21% of trading revenue from derivatives activities.

It should come as no surprise that according to the OCC, from 2003 to 2008 the credit default swap market grew at an annual rate of 100%, fell off in the first quarter of 2009 but has started to bounce back in the second quarter of 2009. After all, credit default swaps are among the most profitable products for the banks that deal them. By the way, according to the OCC the top 5 banks control approximately 93.5% of the market for credit default swaps.

So, who are these “top 5 derivatives banks”?

See for yourself! (Click to enlarge chart.)

I think that the holding company information provided by the OCC makes the situation a lot clearer.

And, please don’t forget that JP Morgan (NYSE:JPM) acquired Bear Stearns, Bank of America (NYSE:BAC) acquired Merrill Lynch and Citigroup (NYSE:C) acquired Salomon Brothers and Philbro.

According to the OCC “all other” includes 1,105 institutions. The category of “all other” is almost irrelevant to the market.

The next time that the debate on derivatives heats up and lobbyists argue that all derivative contracts are great instruments for the U.S. economy, keep in mind who has the most to gain from the status quo and who has the most to lose if derivatives are regulated and listed on an exchange. If all derivatives are listed and traded on an exchange, profitability for the dealers will plunge and markups charged by the banks will become transparent. Transparency and price discovery seems to be great for everyone but the guys who are dealing these instruments and raking in the big bucks.

When “industry experts” get on TV or testify before Congress and say that it is every man’s unalienable right to engage in naked derivatives trading and that naked derivatives trading isn’t the same thing as gambling…well, just think of the above charts and check out the latest OCC quarterly report. You will be able to figure out who wins and who loses from the casino economy.