|Derivatives Could Explode Like A Bomb!|
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!|
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|
|Possibly Why Deutsche Bank Stock Has Fallen|
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 the link below, as always comments are welcome and encouraged.