by The Prudent Investor
October 13, 2008
Here is an update on the size of the derivatives
the latest official figures (.pdf)
Bank for International Settlements (BIS).
Hold your breath, as we are not anymore talking paltry billions but
TRILLIONS of whichever
Current emergency meetings on banks and markets are still only in the stage
where politicians and central bankers are bickering over how to create a few
more hundred billions Euros and FRNs. But toxic MBS pale in comparison to
the mushrooming growth of the derivatives market.
According to figures released in the quarterly
review of the BIS (pp A103) in September the total notional amount of
outstanding derivatives in all categories rose 15% to a mindboggling $596
TRILLION as of December 2007.
Two thirds of contracts by volume or $393 TRILLION fell into the category of
interest rate derivatives. Credit Default Swaps had a notional volume
of $58 TRILLION, seeing the sharpest relative increase after a volume of $43
TRILLION a year earlier.
Currency derivatives reached a volume of $56 TRILLION.
Oh, and every grand balance sheet comes with a trash can. Unallocated
derivatives with a notional amount of $71 TRILLION are looming over the
heads of the disintegrating investment community too.
However You Look At
It, This Is an Accident Waiting To Happen
Don't lose your sleep because of these numbers that KO my desktop
calculator. In an ideal world - in which we are not - long and short
derivatives would net out each other, leaving only a fraction of risk. The
BIS tries to assess this net risk with a total of $14.5 TRILLION (2006: 11.1
TRILLION) in gross market value for all contracts but comes up with a second
The so called Gross Credit Exposure appears almost moderate at $3.256
TRILLION after $2.672 TRILLION a year earlier.
Even when taking the lowest of these figures shudders run down my spine. All
emergency talks have so far focused on a few hundred billions in fiat
currencies, but the current nervousness demonstrated by hectic talks of
finance ministers and central bankers all over the globe should give
everybody a vague idea that something here may blow up any day.
This pool of so far silent derivatives
without a major bust can come to life any day with the failure of a
multinational financial firm.
The BIS review is a good way to grasp the dimensions long term monetary
expansion has brought upon us. A net risk of $14 TRILLION compares with the
annual GDP of the USA. Nobody, absolutely nobody can afford this tab in the
case of an unorderly unwinding of this market that is roughly 12 times the
size of the global economy. I conclude a lot more paper promises will be
burnt in the coming derivatives tsunami.
As a reminder, most of these contracts have been
moved off balance sheets into under capitalized subsidiaries that profited
from the good rating of the parent company. But in case of a default it is
this nasty, nasty huge notional amount that becomes a liability.
As the vast majority of these contracts have no market, failure will come in
the form of counterparty risk. This makes all the current emergency meeting
a bit more understandable if politicians are already aware of the biggest
bubble that may find no other way of deflation than a sudden burst. I base
my sense of urgency on the rapid growth of the net risk in only one year,
rising a stunning 30% at a time when the first signs of the credit crunch
German chancellor Angela Merkel said ahead of an emergency meeting
with French president Nicolas Sarkozy in a TV interview that she
would present a rescue package for German banks on Monday. This is
also expected from several other European countries.
Italian president Silvio Berlusconi went
so far as to suggest a
concerted stock exchange holiday.
It would fit the other crooked nails in the
coffin of free markets.