Monday, June 21, 2004

"Derivatives Wild Card"

Not that I agree totally with this article, but I do agree derivatives bear considerable watching, and that nowhere's near enough professionals understand this market anywhere's near well enough. On the other hand derivatives are one of the best ways of sharing the entire global capitalist risk - with the caveat, they do pose great systemic risk and cost. The costs side of the equation is my greatest concern - not only the speculative, hedging, and arbitrage ability costs, but the massive costs associated with the shear size of the total global turnover in transactions - this turnover transactions figure as recorded by the BIS is $874 trillion. With its formidable growth in recent years, there is surely a systemic limit to these costs even at small percentages of transactions' fees - the sum becomes phenomenal with continued growth. Will it be enough to bring down the entire system if not checked?

Derivatives Wild Card
By Chris Laird

In poker, a wild card can be used to change the rules and introduce excitement. In finance, derivatives do the same thing.

While studying derivatives, I have noticed that even the major financial authorities comment that derivatives are an unknown factor. And the derivatives experts agree the risks are huge, and in many respects indefinable. Which brings me to my point, that derivatives are a new wild card in international banking and finance.

What this means is that nobody knows when or how the derivatives balloon will pop, or what effects it will have. Even in the derivatives field itself it is recognized that there are only a few experts who truly understand the instruments, and that many institutions are lacking in a comprehensive view of the very instruments they are betting 197 trillion dollars on. One thing is certain though, if the derivatives wild card comes into play, systemic monetary collapse is in the cards. We don't know how the hand will be dealt, but the DERIVATIVES WILD CARD will probably be in the hand.

I cannot believe that with $197 trillion in derivatives outstanding as of Dec 2003 (BIS), that there aren't large bad bets made. I cannot believe that they have completely offset their hedges calculating all of the party risks, systemic risks, liquidity risks. I don't believe that the derivatives models are reliable in identifying all the interrelated risks, nor can they be.

The creators and users of derivatives will have us to believe that the instruments are mathematically stable, that they are offset by risk analysis, governed by scientific models. That they are predictable, in fact so predictable that the derivatives users can take $4 billion, and leverage it to over a trillion dollars of notional amounts in derivatives and get away with it. They say that is safe. Wrong!

In the LTCM crisis, LTCM had about 4 billion in net asset value, with assets totaling over 100 billion, and about $1.2 TRILLION in derivatives bets. That represented 5 percent of the derivatives market at that time. That's incredible leverage. When the unexpected happened, (Russian debt defaults), un predicted behavior of LTCM's derivative models resulted in $4 billion evaporating, and left the dealer banks and counter parties of the LTCM derivatives bets defaulting like dominoes, until the FED wrote a blank check. For an explanation of these terms see my GE article entitled Derivatives 101 Big Bets.

But the amounts of derivatives are much greater today. We had 197 trillion in derivatives out at the end of 2003, according to the Bank of International Settlements. In 2001 that figure was 111 trillion. The amount of derivatives has almost doubled in 2 years! Also, of the outstanding derivatives today, the majority by far are interest rate derivatives ( interest rate swaps ) created mostly during the falling interest rate times of recent years.

Here are some stats from the BIS for the first half of 2003.. (footnote 4)

Grand total, Dec 2003 $197 trillion

Interest rate contracts $141 trillion

The interest rate contracts represent 71 percent of the derivatives outstanding. (notional amounts). I believe that the present changing interest rate market represents a gigantic risk to derivatives. If there is only a half point change in interest rates, or 50 basis points, the interest risk exposure comes to $705 billion for $141 trillion, based on interest rate swaps.

Since interest rates are rising today, what are the odds that a percentage of those interest rate derivatives are ALREADY UNDERWATER? Do the calcs. Consider $141 trillion, and say only 1 percent go bad. Well, that's only $1.41 trillion! The point is the carrying charges of those $141 trillion in interest rate derivatives are going up. That is simply one heck of a lot of money by anyone's measure.

I'm willing to bet that, right now, there are large secret derivatives losses being carried by many financial entities as we speak. When any significant weakness in the financial system reveals itself, we will have a wave of cascading derivatives losses as the derivatives wild card comes into play, or derivatives will initiate a systemic monetary crisis caused by cascading defaults. By the way, I don't think that just flooding liquidity into the system will save the day this time either, but that is another story.

Perspective of a central banker on derivatives.

Tony Latter, Deputy Chief of the Hong Kong Monetary Authority stated that derivatives pose "the potential to bring disaster" (footnote 2). That derivatives may pose systemic risks (footnote 3). If you go to the footnote link and read the BIS article, you'll find that while Mr. Latter briefly touches on the subject of the risks involved, he really only talks generically about what a central bank is to do about it. I find the rather limited statement that central banks are there to ensure accountability unconvincing, because he states that they rely on self governance and risk assessment by the financial entities making the derivative bets. I am not impressed by the supposed self governance of many diverse entities wagering $197 trillion and depending on the central banks to bail them out.

If you think about it, the S&L crisis which resulted in about $120 billion in Federal bailouts, pales by comparison to these present numbers of hundreds of trillions in derivatives speculation and hedging today.

I find it interesting that central bankers recognize that risk management is key to the use of derivatives, but the derivatives experts themselves state that analyzing the risk is very problematic and complicated, i.e. assigning risk calculations not only for party defaults, but to systemic risks as well, and that many of the risk models are dated.

Either way, derivatives do introduce gigantic unpredictability to our financial world, they are relatively new, and they are a real financial wild card to the world.

Chris Laird

Footnotes

(1) The chairman of the Hong Kong Monetary authority stated that derivatives are an unknown-known risk ..."Despite for the most part providing a beneficial service, derivative trading also has the potential to bring disaster. Mere mention of the word Barings is no doubt sufficient to make the point. ..." BIS

(2)The chairman of the Hong Kong Monetary authority also stated that risks should be properly identified..."I should perhaps make the point here that supervision is not aimed at suppressing activity, but rather ensuring that risks are properly identified and managed, and that disasters which might threaten systemic stability are avoided. Particular emphasis is placed on ensuring that management possesses sufficient understanding of the derivatives business and the associated risks, and has the appropriate internal mechanisms in place for monitoring and control. BIS

(3) the effects of leveraging in the LTCM crisis mentioned in my GE editorial Derivatives 101 Big Bets Big Bets

(4) BIS 2003 derivatives statistics BIS ...Link

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