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.

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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 ….

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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.”

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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.”

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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?

…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.

The Elite Financial Players Are Manipulating the Game So that They Get the Stimulus … and the Little Guy Gets the Austerity

Liberal economists and financial wonks say that we need to learn the lesson from the 1930s and stimulate more to unnecessarily avoid falling back into a very deep economic abyss.

Conservative economists and financial gurus say that we need to tighten our belts and live within our means, or the tsunami of debt will wipe out our prosperity, and that of our children and grandchildren.

We’ve repeatedly noted that neither stimulus or austerity can ever work … unless and until the basic problems with the economy are fixed.

But stimulus and austerity are not only insufficient on their own … they are actually 2 sides of the same coin.

Specifically, the central banks’ central bank warned in 2008 that bailouts of the big banks would create sovereign debt crises. That is exactly what has happened.

Remember, it is not the people or Main Street who are getting bailed out … it is the giant banks.

A study of 124 banking crises by the International Monetary Fund found that propping up banks which are only pretending to be solvent often leads to austerity:

Existing empirical research has shown that providing assistance to banks and their borrowers can be counterproductive, resulting in increased losses to banks, which often abuse forbearance to take unproductive risks at government expense. The typical result of forbearance is a deeper hole in the net worth of banks, crippling tax burdens to finance bank bailouts, and even more severe credit supply contraction and economic decline than would have occurred in the absence of forbearance.

Cross-country analysis to date also shows that accommodative policy measures (such as substantial liquidity support, explicit government guarantee on financial institutions’ liabilities and forbearance from prudential regulations) tend to be fiscally costly and that these particular policies do not necessarily accelerate the speed of economic recovery.

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All too often, central banks privilege stability over cost in the heat of the containment phase: if so, they may too liberally extend loans to an illiquid bank which is almost certain to prove insolvent anyway. Also, closure of a nonviable bank is often delayed for too long, even when there are clear signs of insolvency (Lindgren, 2003). Since bank closures face many obstacles, there is a tendency to rely instead on blanket government guarantees which, if the government’s fiscal and political position makes them credible, can work albeit at the cost of placing the burden on the budget, typically squeezing future provision of needed public services.

In other words, the “stimulus” to the banks blows up the budget, “squeezing” public services through austerity.

But instead of throwing trillions at the big banks, we could provide stimulus to Main Street. It would work much better at stimulating the economy.

And instead of imposing draconian austerity, we could stop handouts to the big banks, stop getting into imperial military adventures and stop incurring unnecessary interest costs (and see this). This would be better for the economy as well.

Why aren’t we doing this?

Because – underneath the false easing-versus-tightening debate – this is not a financial crisis … it’s a bank robbery.

Profits are being privatized and losses are being socialized.  So the big banks get to keep the mana from heaven being poured out of the stimulus firehose, while austerity is forced on the public who has to bear the brunt of Wall Street’s bad bets.

The big banks went bust, and so did the debtors.  But the government chose to save the big banks instead of the little guy, thus allowing the banks to continue to try to wring every penny of debt out of debtors.  An analogy might be a huge boxer and a smaller boxer who butt heads and are both rendered unconscious … just lying on the mat.   But the referee gives smelling salts to the big guy and doesn’t help the little guy, so the big guy wakes up and pummels the little guy to a pulp.

And creditor committees dominated by giant banks like Goldman which helped countries like Greece fraudulently cover-up their financial problems are now demanding austerity, and Greece is holding a fire sale of its infrastructure, public utilities, tax base and whole islands to give to the creditors.  Spain, Italy, and even countries like the U.S. are no different.

As we wrote last year:

Economists note:

A substantial portion of the profits of the largest banks is essentially a redistribution from taxpayers to the banks, rather than the outcome of market transactions.

Indeed, all of the monetary and economic policy of the last 3 years has helped the wealthiest and penalized everyone else. See this, this and this.

A “jobless recovery” is basically a redistribution of wealth from the little guy to the big boys.

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Economist Steve Keen says:

“This is the biggest transfer of wealth in history”, as the giant banks have handed their toxic debts from fraudulent activities to the countries and their people.

Nobel economist Joseph Stiglitz said in 2009 that Geithner’s toxic asset plan “amounts to robbery of the American people”.

And economist Dean Baker said in 2009 that the true purpose of the bank rescue plans is “a massive redistribution of wealth to the bank shareholders and their top executives”.

The money of individuals, businesses, cities, states and entire nations are disappearing into the abyss …

… and ending up in the pockets of the [fatcats].

Passionate liberal Keynesians and committed fiscal conservatives may each be seeing only part of the picture. We invite everyone to see the bigger picture.

The Issue Is Not Really Regulation … It is a Malignant, Symbiotic Relationship Between Government and Wall Street

In a new debate at Bloomberg, Jeff Madrick - Senior Fellow at the liberal Roosevelt Institute – argues we need more regulation.

Chris Whalen – the top independent bank analyst in the country, and a diehard conservative – argues we need less.

But they both agree that we need more transparency.

And the government could enforce regulations and laws already on the books … like basic fraud law. 

Indeed, as Jarrod Penwell notes, regulation is disproportionately applied too the little guy:

Moreover, the whole left-versus-right melodrama is a fake dichotomy. Specifically, conservatives tend to view big government with suspicion, and think that government should be held accountable and reined in. Liberals tend to view big corporations with suspicion, and think that they should be held accountable and reined in.

In other words, conservatives hate big unfettered government and liberals hate big unchecked corporations, so both hate legislation which encourages the federal government to reward big corporations at the expense of small businesses.

No wonder both liberals and conservatives are angry that the feds are propping up the giant banks – while letting small banks fail by the hundreds – even though that is horrible for the economy and Main Street.

Indeed, the government helped and encouraged the giant banks to get even bigger, and then has hidden their insolvency and shielded them from the free market, and helped them grow even during the severe downturn. In return, the big banks and giant corporations have literally bought and paid for the politicians.

The Dodd-Frank financial legislation wasn’t a compromise where things landed somewhere in the middle between liberal and conservatives ideas. Instead, it enshrines big government propping up the big banks … more or less permanently .

A 2010 Rassmussen poll found:

70% [of all voters] believe that the government and big business typically work together in ways that hurt consumers and investors.

(and see this).

Conservatives might call it “socialism” and liberals might call it “fascism” – they are the same thing economically.

Indeed:

The corrupt, giant banks would never have gotten so big and powerful on their own. In a free market, the leaner banks with sounder business models would be growing, while the giants who made reckless speculative gambles would have gone bust. See this, this and this.

It is the Federal Reserve, Treasury and Congress who have repeatedly bailed out the big banks, ensured they make money at taxpayer expense, exempted them from standard accounting practices and the criminal and fraud laws which govern the little guy, encouraged insane amounts of leverage, and enabled the too big to fail banks – through “moral hazard” – to become even more reckless.

Indeed, the government made them big in the first place:

As MIT economics professor and former IMF chief economist Simon Johnson points out today, the official White House position is that:

(1) The government created the mega-giants, and they are not the product of free market competition

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(3) Giant banks are good for the economy

And given that the 12 Federal Reserve banks are private – see this, this, this and this- the giant banks have a huge amount of influence on what the Fed does. Indeed, the money-center banks in New York control the New York Fed, the most powerful Fed bank. Indeed, Jamie Dimon – the head of JP Morgan Chase – is a Director of the New York Fed.

Any attempt by the left to say that the free market is all bad and the government is all good is naive and counter-productive.

And any attempt by the right to say that we should leave the giant banks alone because that’s the free market are wrong.

The [corrupt, captured government "regulators"] and the giant banks are part of a single malignant, symbiotic relationship.

Indeed, both progressives and conservatives – in America and all over the world – are demanding an end to the crony capitalism which is destroying our economy.