Derivatives Trading: A Dangerous Game

by: Matthew Rafat

Here is one of the best-written articles on the 2008-2009 financial crisis [Washington Lawyer, June 2010]. The numbers in Anna Persky's article are breathtaking, and not in a good way. I've added two other numbers from a recent Economist issue.

300 trillion. The CFTC's Chairman "[Gary] Gensler has estimated that the [2010] OTC derivatives market is worth $300 trillion."

47 trillion. According to a July issue of The Economist, the total value of stock trades executed on the American stock market in 2009 was $47 trillion. American stock markets were "the world’s most active, with shares worth nearly $47 trillion, thrice the market capitalisation, changing hands during the year."

45 trillion. "The market size for credit default swaps increased rapidly—-by 2007 the market had a notional value of $45 trillion, about twice the size of the U.S. stock market."

15.1 trillion. According to a July issue of The Economist, the total market capitalization of the American stock market at the end of 2009 was $15.1 trillion. Also, people traded American-listed stocks so many times in 2009, by the end of the year, the value of their stock trades totaled three times the value of the entire stock market. (See 47 trillion number, above.) And yes, in 2007, just the market for credit default swaps was three times the value of the entire stock market at the close of 2009. Shadow banking, indeed.]

434 billion. "Between 2004 and 2006, Freddie Mac and Fannie Mae, government-chartered mortgage finance firms, purchased $434 billion in securities backed by subprime loans."

On Complexity:

“The beauty and the danger of derivatives is that you can create almost anything, and the degree of complexity that is available is almost limitless,” says Robert A. Wittie, a partner specializing in securities finance and investment management at K&L Gates. “Used properly, that can be terrific. But it can become very opaque. It can be hard for investors to understand the assets they are buying.”

Passing the Buck:

“When you tell someone that they can sell a hand grenade with the pin out, but they don’t need to worry about it because someone else will own it when it goes off,” [Attorney Philip] Johnson says, “you get a lot more hand grenades with the pin out being sold.” [I've talked about this attenuation problem in detail here.]

Canaries in the Coal Mine?: Orange County went bankrupt in 1994 after its treasurer "invested the funds in a leveraged portfolio of mostly interest-sensitive derivatives contracts." Then came Barings Bank in 1995 and LTCM in 1998. The LTCM disaster required a 3.6 billion dollars bailout, which now looks like a paltry sum. In 2001, Enron declared bankruptcy in part due to its derivative trading.

The Fed Asleep at the Wheel?: In 2008, Alan Greenspan emphasized that, excluding credit default swaps, the “derivatives markets are working well.” [Earlier, in 2003, Warren Buffett called financial derivatives “weapons of financial mass destruction.”]

Will the recently passed financial regulation help prevent future problems? On July 15, 2010, CFTC Chairman Gensler said: “The Wall Street reform bill passed today is historic and comprehensive. Over-the-counter derivatives dealers will – for the first time – be subject to robust oversight for their derivatives activities. Standardized derivatives will be required to trade on open platforms and be submitted for clearing to central counterparties. This will greatly improve transparency and lower risk in the marketplace. I look forward to the President signing this crucial legislation. The CFTC stands ready to implement the Dodd-Frank [Wall Street Reform and Consumer Protection] Act to best protect the American public.”

What took Congress so long?