originally posted by: Wrabbit2000
a reply to: WhiteAlice
I hadn't realized you worked with or around derivatives and understand how they work on a professional level. I have a question...
Derivatives: The Unregulated Global Casino for Banks
How accurate is the bottom of that page or was it at the time it was created?
I knew a partner for a mid-sized accounting firm that called the OTC (over-the-counter) derivatives market the "stuff of her nightmares" when I
commented on the size of the financial derivatives market back and asked her opinion of it in 2011. She couldn't even think about it. It scared her
that silly. The growth of the market, after the financial crisis, was alarming and at times, about 150% of what it was the prior year. I stopped
being able to look at it a year or so ago as it really actually made me a little terror struck, too. Honestly, I have to actively reassure myself
that much of the derivative market is actually spread wide across the total market and that it would all collapse is unlikely.
These days it appears to be increasing about $100 trillion a year. The notional value of all outstanding derivatives contract at the end of 2013 was
$710 trillion. I know you like your data so here's a link for you that breaks down that $710 trillion at year end 2013.
One thing to keep in mind, which is what I always do when looking at these numbers, is to remember that not all derivatives are the same. The primary
derivative most strongly associated with the Financial Crisis was credit default swaps (CDS). Page 7 of the above pdf discusses the market for CDS.
Compared to the larger total amount of the derivatives market in its entirety, it comprises a small portion of it. That's a big of a relief as long
as you don't recall that it is still in the trillions.
The largest portion of financial institution derivatives would be interest rate derivatives (page 5). A really basic explanation of those is that
they are bets on future interest rate fluctuations. One party bets that it's going to go up and the other bets that it's going to go down. What
the interest rate derivative is based on varies but one of the most common is US Treasury bonds. FRA, which you'll see be mentioned, is a forward
rate agreement. That's basically that up and down bet where the payment is made at the maturity of the contract. They can be very short term (1
month) so the FRA market is very active and they typically use LIBOR as their reference rate. The calculation for who pays what is basically the
difference between the reference rate and the fixed rate over the days of the term of the contract, divided by 1+ the reference rate over that same
period. Confusing, no? And that's the kind of dumbed down version.
More lovely data for you: www.bis.org...
My three concerns with this portion of the OTC derivatives market is 1. the sheer enormity, 2. the fact that, despite the LIBOR scandal, many utilize
LIBOR, which in my mind just risks a repeat/temptation to fiddle, and 3. as BIS states, they are "opaque". It's hard to know what is going on with
them, especially when they can be so short term, coupled with the sheer number of them. Unlike CDS, a significant portion of interest rate
derivatives do not go through central clearing as mandated for some OTC derivatives by Dodd-Frank here in the US and other international laws
developed since the Financial Crisis.
There is a significant problem with the whole central clearing response and that is that the largest banks are the central counter party (CCP)
clearing houses that are being used. They're acting as the go between of the two parties involved in the derivative contract and to whom the parties
must provide collateral to. While it's not a bad idea and does mitigate that risk between the two parties. Basically, if they were to go into a
contract and one party loses and is found to be insolvent, the other party is SOL. By having a centralized entity as go-between, assessor and
collateral holder, it lessens that risk of somebody being hung out to dry on a derivative contract. It is still kind of problematic as, if these
banks were "too big to fail" before, then surely they really are now as CCPs and that's just my most immediate thought on that one, lol.
And that is probably more than you ever wanted to know about the derivatives market. Hopefully that didn't confuse the crap out of you or make your
head hurt. There's a whole lot of OTC derivatives and they can be on everything from currencies, bonds, other obligations, the price of a commodity
and much, much more. That's why, when I look at that monster number, I remind myself of that fact. You could have a company with $50 trillion in
derivatives but that $50 trillion could be spread far and wide on the market. Having it get hit for that entire $50 trillion is unlikely.
Part of mitigating risk is avoiding having all your eggs in one basket so to speak. If all your eggs are in one basket, then your risk isn't being
mitigated at all. It's better to have your eggs in multiple baskets in case one falls. It still is kind of scary though.