Derivatives Could Explode Like A Bomb!

by: Bruce Wilds

On occasion, it is important to revisit issues that have been swept under the rug or simply overlooked. For most people, the derivatives market falls into this category, partly because they don't understand exactly what derivatives are or why this market is so important. Trying to regulate this complex market is easier said than done. These are usually lengthy complex legally binding agreements that are very difficult to dissect and often reek with possible contagion. Derivatives fall into many categories from futures, options, credit default swaps, and any complex combinations of these. They can also be used to wager, bet, and spectate on a market move or direction. Regulation is difficult and spotty at best in that a derivative transaction in one country might be considered a simple spot trade in another. I have become convinced after studying derivatives that QE following the 2008 financial crisis may have been geared to hold up the underlying value of assets that feed into and support the massive derivative market more than help the economy.

Derivatives Could Explode Like A Bomb!

While QE was able to halt an implosion of derivatives and the resulting contagion and shock that would have spread throughout the financial system following the 2008 financial crisis next time we may not be so lucky. In the middle of 2014, the Bank for International Settlements revealed that the amount of over-the-counter (OTC) derivatives outstanding reached 710 trillion dollars at the end of 2013, a 12 percent increase on the year before. Most of that exposure is held by banks. The US Office of the Comptroller of the Currency at the time reported the exposure of US banks to derivatives totaled 237 trillion dollars. Of that, four big banks, JP Morgan Chase, Citibank, Goldman Sachs and Bank of America account for over 219 trillion dollars. The staggering size of this market is beyond science fiction or anything that can be comprehended.

When I tried to get more recent numbers I ran into fairly stiff resistance which I contribute to the fact nobody really knows and the true exposure is difficult to assess, hopefully, much of the derivative exposure somehow nets out so that real exposure is far less than the hundreds of trillions of dollars on the books. Still, the situation is so worrying to the Federal Reserve that after announcing the third round of quantitative easing which included printing money to buy bonds (both US Treasuries and the banks’ bad assets) it also announced that it was doubling its QE 3 purchases. In other words, the entire economic policy of the United States appears to have been dedicated to saving four banks that are too big to fail. Yes, the main purpose of QE has been to keep the up prices to support the debt on which banks have loaned money.

Everyone paying attention knows that the size of the derivatives market dwarfs the global economy. Paul Wilmott who holds a doctorate in applied mathematics from Oxford University has written several books on derivatives. Wilmott estimates the derivatives market at $1.2 quadrillion, to put that in perspective it is about 20 times the size of the world economy. The world’s annual gross domestic product is around 55 trillion dollars. The Bank of International Settlements regularly publishes tables showing the amounts of different types of derivatives but these categories are ambiguous making it hard to get a good handle on what’s really out there.

The top markets regulator in the EU, the European Securities and Markets Authority have asked the European Commission to clarify what a derivative is. There is no single commonly adopted definition of derivative or derivative contract in the European Union. This plays havoc with what and when reporting rules apply. It also highlights divisions in how national regulators view reporting rules for the $693 trillion over-the-counter derivatives market. Remember this is only part of a much larger market that includes hundreds of trillions of dollars in non-reported agreements and private contracts. The efforts to achieve more reporting, more platform trading and central clearing of derivatives have fallen behind because of the "complexity of crafting mutually consistent regulations at the jurisdiction level, for a market that is highly globalized in operation".

While This Is Not A Current Chart Note The Trend Line!

Many of these writers of derivative might be called "too clever by half" if they think they have successfully controlled the risk or removed the implications and problems a default would cause. This is because they make money in the process of structuring and selling these agreements. A derivative is in many cases an insurance policy covered by collateral. Sadly, those who buy and write derivatives often play fast and loose with the value of the collateral or flat out lie about it. This moves them from an insurance policy and into the area of high risk. Although central banks and bank regulators are working hard to control banks' balance sheet leverage before the next crisis hits, the continuing growth in derivatives trading by banks is undermining those efforts. To view a good video to learn more about what constitutes a derivative clink on the link here.

My point of unquantified risk was reinforced with the now forgotten closing of Mt. Gox, a major Bitcoin exchange in Japan. This bankruptcy has not only focused attention on the risk of digital currency, but it also rattled a still-newer market that regulators are just starting to monitor that of Bitcoin derivatives. The regulation of Bitcoin, let alone derivatives of it is unresolved in many parts of the world. Even as regulators and investors struggle to grasp Bitcoin’s many uses and where it fits into the complex world of currencies they are now confronted with the additional complexities of an emerging derivatives market where entrepreneurs say current rules don’t apply. How do you properly value and assess the risk of such transactions? While the top US derivatives regulator, the Commodity Futures Trading Commission has lawyers considering if and how to oversee derivatives linked to Bitcoin and other digital currencies this area remains untamed.

The Growth In Derivatives Is Troubling

The point of this article is to call attention to the insanity of derivatives as an instrument or tool to add stability to our financial system. By stacking risk upon risk and transferring it off to another party who may not be able to perform or is over-leveraged you do not increase stability. Derivatives do just that with the parties involved often not even understanding the terms and implications of what they have signed. To make things more complicated cross-border agreements blur regulations, legal jurisdictions, and laws. A collapse or default often results in years of legal wrangling and finger pointing rather than a swift payout or settlement.

Possibly Why Deutsche Bank Stock Has Fallen

It seems that the leverage problem these days is not excessive lending on housing, as it was in 2005-06, but exposure to derivatives. By far the largest type of derivatives trading involves interest rate swaps, in which two parties agree to exchange interest cash flows, usually with one of them paying a fixed-rate and getting a floating rate in return. It's simply a way of betting on interest rate movements instead of horses and always involves significant leverage. It's true that banks are able to use interest rate swaps to hedge their exposure to a certain movement interest rates, but for example JP Morgan's total assets are 1.5 trillion dollars while its exposure to derivatives is a massive 70 trillion dollars or 47 times its assets, so you'd have to think there is rather more gambling going on than hedging.

This is why I refer to derivatives as a house of cards. When one party fails these agreements are often so highly leveraged the transfer of the obligation or debt can put massive pressure and strain directly upon another party. We must question the quality of many of these contracts and worry about the potential of them to turn toxic. Contagion from insuring a contract or acting as an agent in case of default can be devastating with the obligation shifting to another party rather than simply vanishing. My father often said, "squeeze all you want but you can't get blood out of a turnip." This will be the case with those on the hook for trillions of dollars when the silly but real derivatives market heads south. Again this issue is about paper promises that can vanish rather than tangible and hard assets. Derivative bets are not a zero sum game and have far reaching consequences in the real world. Often debt crisis become apparent as or when a liquidity crisis appears in the financial system and have no doubt derivative have the potential to be the catalyst for such an event.

Footnote; For another article that delves into the environment that has allowed the number of derivative to surge see this link, as always comments are welcome and encouraged.

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