Top Derivatives Expert Estimates Size of the Global Derivatives Market at $1,200 Trillion Dollars … 20 Times Larger than the Global Economy

How Large Is the Derivatives Market?

Everyone paying attention knows that the size of the derivatives market dwarfs the global economy.  But how big is it really?

For years, there have been rumors that there is over a quadrillion – one thousand trillion – dollars in notional value of outstanding derivatives.  But no one really knew.

Even though the Bank of International Settlements regularly publishes tables showing the amounts of different types of derivatives, some of the categories are ambiguous, and so it has been hard to get a good handle on what’s really out there.

For example, one blogger wrote last year:

Estimates of the notional value of the worldwide derivatives market go from $600 trillion all the way up to $1.5 quadrillion.

Smart guys like bond trader Jeffrey Gundlach said last year that we’ve got a quadrillion dollar derivative overhang, the government hasn’t done anything to fix the basic problems in our economy, and so we’ll have another crash.

But I’ve now found an estimate from a top derivatives expert who  confirms the claim.

Specifically, Paul Wilmott – who has written numerous books on the subject – estimated the number last year at $1.2 quadrillion:

The… derivatives market … is 20 times the size of the world economy.

***

According to one of the world’s leading derivatives experts, Paul Wilmott, who holds a doctorate in applied mathematics from Oxford University (and whose speaking voice sounds eerily like John Lennon’s), $1.2 quadrillion is the so-called notional value of the worldwide derivatives market. To put that in perspective, the world’s annual gross domestic product is between $50 trillion and $60 trillion.

A Clear and Present Danger to the World Economy

The size of the derivatives market is a huge threat to the world economy:

One of the biggest risks to the world’s financial health is the $1.2 quadrillion derivatives market. It’s complex, it’s unregulated, and it ought to be of concern to world leaders ….

***

How big is the risk to the world economy from these derivatives? According to Wilmott, it’s impossible to know unless you understand the details of the derivatives contracts. But since they’re unregulated and likely to remain so, it is hard to gauge the risk.

But Wilmott gives an example of an over-the-counter “customized” derivative that could be very risky indeed, and could also put its practitioners in a position of what he called “moral hazard.”

***

Another kind of market conduct that makes markets volatile is what Wilmott calls positive and negative feedback loops. These relatively bland-sounding terms mask some really scary behavior for investors who are not clued into it. Wilmott argues that a positive feedback loop contributed to the 22.6% crash in the Dow back in October 1987.

As we noted last year:

Bloomberg reported in May:

Mark Mobius, executive chairman of Templeton Asset Management’s emerging markets group, said another financial crisis is inevitable because the causes of the previous one haven’t been resolved.

“There is definitely going to be another financial crisis around the corner because we haven’t solved any of the things that caused the previous crisis,” Mobius said …“Are the derivatives regulated? No. Are you still getting growth in derivatives? Yes.”

***

The global financial crisis three years ago was caused in part by the proliferation of derivative products tied to U.S. home loans that ceased performing, triggering hundreds of billions of dollars in writedowns and leading to the collapse of Lehman Brothers Holdings Inc. in September 2008.

Credit default swaps were largely responsible for bringing down Bear Stearns, AIG (and see this), WaMu and other mammoth corporations.

And unexpected changes in interest rates could cause a major bloodbath in interest rate derivatives.

And, no, there have not been any reforms or attempts to rein in derivatives, and the Dodd-Frank financial legislation was really just a p.r. stunt which didn’t really change anything.

But the big banks and their minions claim that the huge amounts of derivatives themselves is unimportant because these are only “notional” values, and – after netting – the notional values are deflated to much more modest numbers.

But as [Tyler] Durden – who has a solid background in derivatives – notes:

At this point the economist PhD readers will scream: “this is total BS – after all you have bilateral netting which eliminates net bank exposure almost entirely.” True: that is precisely what the OCC will say too. As the chart below shows, according to the chief regulator of the derivative space in Q2 netting benefits amounted to an almost record 90.8% of gross exposure, so while seemingly massive, those XXX trillion numbers are really quite, quite small… Right?

Netting Amount and Concentration of Derivatives Still Threaten Global Economy

…Wrong. The problem with bilateral netting is that it is based on one massively flawed assumption, namely that in an orderly collapse all derivative contracts will be honored by the issuing bank (in this case the company that has sold the protection, and which the buyer of protection hopes will offset the protection it in turn has sold). The best example of how the flaw behind bilateral netting almost destroyed the system is AIG: the insurance company was hours away from making trillions of derivative contracts worthless if it were to implode, leaving all those who had bought protection from the firm worthless, a contingency only Goldman hedged by buying protection on AIG. And while the argument can further be extended that in bankruptcy a perfectly netted bankrupt entity would make someone else whole on claims they have written, this is not true, as the bankrupt estate will pursue 100 cent recovery on its claims even under Chapter 11, while claims the estate had written end up as General Unsecured Claims which as Lehman has demonstrated will collect 20 cents on the dollar if they are lucky.

The point of this detour being that if any of these four banks fails, the repercussions would be disastrous. And no, Frank Dodd’s bank “resolution” provision would do absolutely nothing to prevent an epic systemic collapse.

 

This entry was posted in Business / Economics, Politics / World News. Bookmark the permalink.
  • ncal

    The U.S. derivatives market has shrunk from $60T in June, 2008 to $25.5T in 2012. Obama forced the banks to recapitalize with his stress tests. The Enron Loophole Repeal (Jun 2008) caused the first $15T loss; and then the investment capital requirements (except the % forgiven via Scott Brown) account for the rest of the de-investment. (JPMC’s recent loss fell within that Scott margin of error.) Sheila Bair had a lot to do with the new rules of the road. That said, except for the first $15T loss going back to the economy of supply/demand, it could simply be re-invested in the (unregulated) worldwide derivative market.

  • ncal

    Should have been way more specific. The numbers are Credit Default Swaps, not the whole derivative market.

  • Endo

    Definitely a much higher number than $1.2 Quadrillion. It was supposedly that much two years ago in 2010. And this article says last year. So I’d like to know the numbers for this year.

  • http://goo.gl/efdf3 Communal Award

    There is about $900 billion dollar bills and coins in circulation as on June 20, 2012
    There is about $15 trillion dollars worth of credit supplied by banks.
    There is about $55 trillion dollars in total debt, again, supplied by banks.
    What backs the dollar is the faith that the $14 trillion dollars will some day pay the $55 trillion dollars (plus $217 trillion dollars derivatives contracts) off.

  • Pixeljim

    This sounds like really scarey stuff. I only recently heard about $600TRILLION derivatives and found this article in my search to see what it is all about. I am recently retired (65) cashed out of the stock market and invested in several rental SF houses. My total income is based on rentals and a small SS, no corp pension. My question to whoever can guess is what happens if the derivative bubble market explodes(or implodes) in regards to realestate. What should one do to protect assets. I am not a big fan of gold as I can’t see my local grocer taking gold for food. Jim in AZ

  • http://comparegoldandsilverprices.com/ Mike

    How can you sell and resell something multiple times? The whole thing is a scam. How can this be legal?

    • John Richards

      Good question, I’ve been puzzling this too, the 2008 version, and maybe some smart folks out there can tell me if I have it about right. So I buy a house, and take out a $200K Mortgage (no downpayment) with say, Wells Fargo. WF sells it to Goldman Sachs (transaction 1). GS takes it and strips out tranches of repayment, bundled with the same tranches from 100 other mortgages, and sells it as a CDO to, say, Greece, as part of a refinancing deal on their sovereign debt. (Transaction #2). They do this with several sets of tranches, so maybe there are now 5 CDOs all with a part of my mortgage. Greece now buys an insurance contract against the threat of default. (Transaction #3). The notional value of the derivatives from transaction 2 (and related CDOs) and 3 is now $400K, or 2x the value of the financed asset. Appreciate any perspectives/corrections that can be offered.

    • John Richards

      Good question, I’ve been puzzling this too, the 2008 version, and maybe some smart folks out there can tell me if I have it about right. So I buy a house, and take out a $200K Mortgage (no downpayment) with say, Wells Fargo. WF sells it to Goldman Sachs (transaction 1). GS takes it and strips out tranches of repayment, bundled with the same tranches from 100 other mortgages, and sells it as a CDO to, say, Greece, as part of a refinancing deal on their sovereign debt. (Transaction #2). They do this with several sets of tranches, so maybe there are now 5 CDOs all with a part of my mortgage. Greece now buys an insurance contract against the threat of default. (Transaction #3). The notional value of the derivatives from transaction 2 (and related CDOs) and 3 is now $400K, or 2x the value of the financed asset. Appreciate any perspectives/corrections that can be offered.

  • infinitiderivatives
  • Brandon Reed

    I don’t really think the problem here is the recession threat, its that its taken so long to recover. We need to have more liberalization, not regulation, so that when the bubble bursts we can recover quicker. That would be how I believe the future trend leads. Quick recession and quick recovery. Adding regulation would lead to a prolonged recovery like we are seeing now. If there were less regulation on the banking sector, then new banking entrants could replace the current banks that we have and operate at a much lower margin than banks we have used thus far. Regulation is a weapon of incumbents to slow disruption of their industry and market, liberalization would likely fuel a quicker recovery.

 

 

Twitter