Derivatives A House Of Cards

Derivative bets are not a zero sum game and have far reaching consequences in the real world. 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.

Derivatives Could Explode Like A Bomb!

The more and more I study derivatives it now appears the main goal of QE may have been to hold up the underlying value of assets that feed into and support the massive derivative market more than help the economy. QE has up to now stopped an implosion of derivatives and the resulting contagion and shock that would have spread throughout the financial system. According to the Office of the Comptroller of the Currency’s fourth quarter report for 2011, about 95% of the $230 trillion in US derivative exposure is held by four US financial institutions: JP Morgan Chase Bank, Bank of America, Citibank, and Goldman Sachs. The staggering size of this market is beyond science fiction or anything that can be comprehended.

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 has been dedicated to saving four banks that are too big to fail. Yes, the main purpose of QE is to keep the up prices to support the debt on which banks have loaned money.

Recently the top markets regulator in the EU, the European Securities and Markets Authority, 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.

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.

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. To view a good video to learn more about what constitutes a derivative clink on the link below;
               http://wn.com/derivatives_market

My point of unquantified risk is reinforced with the closing last week 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?

It is reported 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. The agency has been preparing an internal memo that examines CFTC’s authority over digital currencies and how it might exercise those powers to regulate the markets. Over the last year, Bitcoin’s price rose from $20, peaked at $1,147 and dropped to as low as $534.71 on Feb. 25. Bitcoin investors who can hedge against the price falling would have less reason to dump the volatile currency in a panic, contributing further to stability.

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.

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 we are talking about paper and promises that can vanish rather than tangible and hard assets.


 Footnote; For more articles that may relate to this post see the posts below, comments are welcome and encouraged,
            http://brucewilds.blogspot.com/2014/02/contagion-may-lead-to-new-world-currency.html
            http://brucewilds.blogspot.com/2012/11/what-is-something-worth.html