The Size of Derivatives Bubble = $190K Per Person on Planet
By Tom Foremski - October 16, 2008
More must read financial analysis from DK Matai, Chairman of the ACTA Open.
The Invisible One Quadrillion Dollar Equation -- Asymmetric Leverage and Systemic RiskAccording to various distinguished sources including the Bank for International Settlements (BIS) in Basel, Switzerland -- the central bankers' bank -- the amount of outstanding derivatives worldwide as of December 2007 crossed USD 1.144 Quadrillion, ie, USD 1,144 Trillion. The main categories of the USD 1.144 Quadrillion derivatives market were the following:
1. Listed credit derivatives stood at USD 548 trillion;
2. The Over-The-Counter (OTC) derivatives stood in notional or face value at USD 596 trillion and included:
a. Interest Rate Derivatives at about USD 393+ trillion;
b. Credit Default Swaps at about USD 58+ trillion;
c. Foreign Exchange Derivatives at about USD 56+ trillion;
d. Commodity Derivatives at about USD 9 trillion;
e. Equity Linked Derivatives at about USD 8.5 trillion; and
f. Unallocated Derivatives at about USD 71+ trillion.
Quadrillion? That is a number only super computing engineers and astronomers used to use, not economists and bankers! For example, the North star is "just" a couple of quadrillion miles away, ie, a few thousand trillion miles. The new "Roadrunner" supercomputer built by IBM for the US Department of Energy's Los Alamos National Laboratory has achieved a peak performance of 1.026 Peta Flop per second -- becoming the first supercomputer ever to reach this milestone. One Quadrillion Floating Point Operations (Flops) per second is 1 Peta Flop/s, ie, 1,000 Trillion Flops per second. It is estimated that all the data found on all the websites and stored on computers across the world totals more than One Exa byte of memory, ie, 1,000 Quadrillion bytes of data.
Whilst outstanding derivatives are notional amounts until they are crystallised, actual exposure is measured by the net credit equivalent. This is normally a lower figure unless many variables plot a locus in the wrong direction simultaneously. This could be because of catastrophic unpredictable events, ie, "Black Swans", such as cascades of bankruptcies and nationalisations, when the net exposure can balloon and become considerably larger or indeed because some extremely dislocating geo-political or geo-physical events take place simultaneously. Also, the notional value becomes real value when either counterparty to the OTC derivative goes bankrupt. This means that no large OTC derivative house can be allowed to go broke without falling into the arms of another. Whatever funds within reason are required to rescue failing international investment banks, deposit banks and financial entities ought to be provided on a case by case basis. This is the asymmetric nature of derivatives and here lies the potential for systemic risk to the global economic system and financial markets if nothing is done.
Let us think about the invisible USD 1.144 quadrillion equation with black swan variables -- ie, 1,144 trillion dollars in terms of outstanding derivatives, global Gross Domestic Product (GDP), real estate, world stock and bond markets coupled with unknown unknowns or "Black Swans". What would be the relative positioning of USD 1.144 quadrillion for outstanding derivatives, ie, what is their scale:
1. The entire GDP of the US is about USD 14 trillion.
2. The entire US money supply is also about USD 15 trillion.
3. The GDP of the entire world is USD 50 trillion. USD 1,144 trillion is 22 times the GDP of the whole world.
4. The real estate of the entire world is valued at about USD 75 trillion.
5. The world stock and bond markets are valued at about USD 100 trillion.
6. The big banks alone own about USD 140 trillion in derivatives.
7. Bear Stearns had USD 13+ trillion in derivatives and went bankrupt in March. Freddie Mac, Fannie Mae, Lehman Brothers and AIG have all 'collapsed' because of complex securities and derivatives exposures in September.
8. The population of the whole planet is about 6 billion people. So the derivatives market alone represents about USD 190,000 per person on the planet.
The Impact of Derivatives
1. Derivatives are securities whose value depends on the underlying value of other basic securities and associated risks. Derivatives have exploded in use over the past two decades. We cannot even properly define many classes of derivatives because they are highly complex instruments and come in many shapes, sizes, colours and flavours and display different characteristics under different market conditions.
2. Derivatives are unregulated, not traded on any public exchange, without universal standards, dealt with by private agreement, not transparent, have no open bid/ask market, are unguaranteed, have no central clearing house, and are just not really tangible.
3. Derivatives include such well known instruments as futures and options which are actively traded on numerous exchanges as well as numerous over-the-counter instruments such as interest rate swaps, forward contracts in foreign exchange and interest rates, and various commodity and equity instruments.
4. Everyone from the large financial institutions, governments, corporations, mutual and pension funds, to hedge funds, and large and small speculators, uses derivatives. However, they have never existed in history with the overarching, exorbitant scale that they now do.
5. Derivatives are unravelling at a fast rate with the start of the "Great Unwind" of the global credit markets which began in July 2007 and particularly after the collapse of Freddie Mac and Fannie Mae in September this year.
6. When derivatives unravel significantly the entire world economy would be at peril, given the relatively smaller scale of the world economy by comparison.
7. The derivatives market collapse could make the housing and stock market collapses look incidental.
Three Historical Examples
1. The so-called rogue trader Nick Leeson who made a huge derivatives bet on the direction of the Japanese Nikkei index brought on the collapse of Barings Bank in 1995.
2. The collapse of Long Term Capital Management (LTCM), a hedge fund that had a former derivatives and bond dealer from Salomon Brothers and two Nobel Prize winners in Economics as principals, collapsed because of huge leveraged bets in currencies and bonds in 1998.
3. Finally, a lot of the problems of Enron in 2000 were brought on by leveraged derivatives and using derivatives to hide problems on the balance sheet.
The Pitfall
The single conceptual pitfall at the basis of the disorderly growth of the global derivatives market is the postulate of hedging and netting, which lies at the basis of each model and of the whole regulatory environment hyper structure. Perfect hedges and perfect netting require functioning markets. When one or more markets become dysfunctional, the whole deck of cards could collapse swiftly. To hope, as US Treasury Secretary Mr Henry Paulson does, that an accounting ruse such as transferring liabilities, however priced, from a private to a public agent will restore the functionality of markets implies a drastic jump in logic. Markets function only when:
1. There is a price level at which demand meets supply; and more importantly when
2. Both sides believe in each other's capacity to deliver.
Satisfying criterion 1. without satisfying criterion 2. which is essentially about trust, gets one nowhere in the long term, although in the short term, the markets may demonstrate momentary relief and euphoria.
Conclusion
In the context of the USD 700 billion rescue plan -- still being finalised in Washington, DC -- the following is worth considering step by step. Decision makers are rightly concerned about alleviating immediate pressure points in the global financial system, such as, the mortgage crisis, decline in consumer spending and the looming loss of confidence in financial institutions. However, whilst these problems are grave, they are acting as a catalyst to another more massive challenge which may have to be tackled across many nation states simultaneously. As money flows slow down sharply, confidence levels would decline across the globe, and trust would be broken asymmetrically, ie, the time taken to repair it would be much longer. Unless there is government action in concert, this could ignite a chain-reaction which would swiftly purge trillions and trillions of dollars in over-leveraged risky bets. Within the context of over-leverage, the biggest problem of all is to do with "Derivatives", of which CDSs are a minor subset. Warren Buffett has said the derivatives neutron bomb has the potential to destroy the entire world economy, and is a "disaster waiting to happen." He has also referred to derivatives as Weapons of Mass Destruction (WMD). Counting one dollar per second, it would take 32 million years to count to one Quadrillion. The numbers we are dealing with are absolutely astronomical and from the realms of super computing we have stepped into global economics. There is a sense of no sustainability and lack of longevity in the "Invisible One Quadrillion Dollar Equation" of the derivatives market especially with attendant Black Swan variables causing multiple implosions amongst financial institutions and counterparties! The only way out, albeit painful, is via discretionary case-by-case government intervention on an unprecedented scale. Securing the savings and assets of ordinary citizens ought to be the number one concern in directing such policy.
[ENDS]
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Best wishes
DK Matai
Chairman, ATCA Open
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Comments (24)
Very interesting numbers. Good article. I read that they have to build a new debt clock because it doesnt have enough digits anymore. Here is the article http://www.gotoguy.com/?p=458
Posted: October 17, 2008 7:10 AM
1. If one quadrillion takes 32 million years to count - stop counting it. The solution is not in figuring how big it is and how it got there. Simple. How did George W. Bush get people to believe in WMD? - Lies based on fear. How did we get to one Qn of derivatives ? - Lies based on greed.
2. Look at it this way. Derivatives are like the foilage on a tree. One giant Oak produces millions of leaves. When these leaves get diseased, the disease will eventually find its way to the roots and kill it. Unlike the natural aging of a tree when the root system gets weak and cannot support the foilage and diseases manifest, derivatives are diseases planted on top of otherwise healthy trees.
Remember - An aged tree that has reached its natural life span must be left to die naturally or be cut down to prevent its collapse and inflicting damage. A little sorting need be done.
To save an otherwise healthy but diseased tree normally requires 2 steps.
1. Cut away the diseased foilage - let the derivatives die. Some people/institutions (the most greedy ones) will suffer. Much as you may fear, most of the time, this will not kill a basically healthy tree.
2. At the same time, treat the trees systemically from the roots up.
Done in the right proportions (of trimming and insecticides and fertilizers) most trees wiil survive and grow again.
I leave you geniuses to figure out hoe to apply this to the 1 Qn derivatives problem.
Posted: November 16, 2008 11:05 AM
how on earth can these government bailouts even make a dent in the figures mentioned here. There needs to be some very slick thinking applied here and quickly. Personally I think the money should go to the needy not the greedy.Let them fall naturally one at a time until a natural level is found from which we can plan to move forward from with at least some certainty.Most of this crap is journal entry not real cash anyhow, so write it off and start again with proper checks and balances in place.Currencies are for the use of communities not for hording by sick freaks who get their rocks off on power tripping.Send them a lesson they will never forget. Break them now!!
Posted: November 24, 2008 5:31 AM
Thank you so much for making DK Matai's work accessible to someone in rural central Ohio.
I just made a comment to an article in the Seattle Times on securitization ( http://seattletimes.nwsource.com/html/businesstechnology/2008477995_toxicdebt070.html ) that referred back to this page. If this is inappropriate, please let me know.
Posted: December 7, 2008 2:51 PM
This is a fantastic article.
It points out perfectly one of the falicies of capitalism. Capitalism is touted as the most efficient means to run an economy and indeed a society, but that is not always true.
Capitalism breeds cooperation only when there is a tangible gain to be had by the cooperating parties. That's all fine and well, but often a 3rd party bears some expense, and is not compensated for it.
In my opinion, by not taking the 3rd party into consideration, the swaps as a contract should be invalidated.
Posted: February 3, 2009 6:56 PM
I am so glad to see this Quadrillion figure finally getting some traction. That is exactly what we are dealing with. I knew it months ago:
http://mikecane2008.wordpress.com/2008/11/03/chronicles-of-depression-20-364-quadrillion/
And there is only ONE way out of it:
http://mikecane2008.wordpress.com/2008/11/20/chronicles-of-depression-20-427-777/
How many millions must starve, how many governments must fall, how much chaos must we endure before that step is recognized and taken?
http://www.telegraph.co.uk/finance/comment/ambroseevans_pritchard/4285187/Biblical-debt-jubilee-may-be-the-only-answer.html
Posted: March 15, 2009 9:11 AM
this is why we will not recover so quickly.
Posted: March 15, 2009 10:39 AM
Table 19: Amounts outstanding of over-the-counter (OTC) derivatives
My understanding of the BIS numbers is different. 683 trillions is the overall number and the 60 trillion fx contracts are included in the 683 trillions.
But even then you'll get an derivatives exposure of more than 100.000 dollar ...
Posted: March 15, 2009 4:17 PM
Stop the insanity!
Posted: March 15, 2009 6:57 PM
Capitalism is insanity. This crisis is completely arbitrary and artificial but has such devastating consequences for 99.99% of the world who had nothing to do with setting up this situation. The bankers and politicians responsible should be jailed. How can anyone not be a socialist right now? We need to build a system based on human needs, it is the only way out.
Posted: March 16, 2009 7:12 AM
Before you add numbers together, it would be helpful if you understood what they represent. Adding these numbers as you have done makes no sense.
There is a huge difference between derivatives such as futures traded on exchanges with well established margin requirements and clearing mechanisms vs off exchange contracts between counterparties.
Posted: March 16, 2009 2:05 PM
To quote Han Solo from the first Star Wars movie, "I'm getting a bad feeling about this,..."
Posted: March 16, 2009 3:42 PM
Once is an accident, twice is a coincidence, three times is a declaration of war; four times is the realization the declaration went unheard, five times is rape and six is hopefully the last.
Some notes from 'A Uniform Field Theory of Economics'; or 'Grand Theft Planet'by Tom Dennen.
"Exponential economic growth required by the mathematics of compound interest on a money supply based on money as debt must always run up eventually against the finite nature of Earth's resources." - British financial analyst Chris Cook.
'Unregulated financial market' means that banks have been allowed to charge compound interest.
Even ancient Rome capped interest at max 5% and compound interest (usury) was outlawed (See Tacitus, The Annals of Rome, Chapter Six, a.d. 29).
"There is a nine-year period between a commodity peak and a market crash. Add forty-six to that (the average period between crashes) and you have a fifty-year-odd boom-bust cycle or once a generation we are plucked.- Tom Dennen, "A Unified Field Theory of Economics" (in progress.)
The above thought and the following compilation are from 'The Great Reckoning' by James Dale Davidson and William Rees-Mogg, Sidgwick & Jackson, 1993.
* First time: Commodity prices peaked in London in 1711 (Long before America came into the economic picture). The South Sea Bubble burst nine years later in 1720. Depression followed.
* Second: Producer prices peaked in London in 1763. The London stock market crashed again in 1772 (nine years later). Depression followed.
* Third: Commodity prices peaked in London in 1816.The London stock market crashed in 1825 (nine years later). Depression followed.
* Fourth: Wholesale prices peaked in New York in 1864. A worldwide assets crash began in May 1873 (nine years later). Depression followed.
* Fifth: Then followed our beloved Great Depression in the 30s, about which much has been said, from which, little learned.
* Sixth: Commodity prices peaked some fifty years later in Tokyo, in 1980. The Tokyo stock market peaked in 1989 (again, nine years later) and crashed in 1990. The depression following that crash is now upon us.
“I call this one, 'Grand Theft, Planet”, ibid, t.d.
From an article by Tom Foremski in the Silicon Watcher - October 16, 2008
"According to various distinguished sources including the Bank for International Settlements (BIS) in Basel, Switzerland -- the central bankers' central bank -- the amount of outstanding derivatives worldwide as of December 2007 crossed USD 1.144 Quadrillion, ie, USD 1,144 Trillion. The main categories of the USD 1.144 Quadrillion derivatives market were the following:
1. Listed credit derivatives stood at USD 548 trillion;
2. The Over-The-Counter (OTC) derivatives stood in notional or face value at USD 596 trillion and included:
a. Interest Rate Derivatives at about USD 393+ trillion;
b. Credit Default Swaps at about USD 58+ trillion;
c. Foreign Exchange Derivatives at about USD 56+ trillion;
d. Commodity Derivatives at about USD 9 trillion;
e. Equity Linked Derivatives at about USD 8.5 trillion; and
f. Unallocated Derivatives at about USD 71+ trillion.
The Size of Derivatives Bubble now equals $190K Per Person on the Planet.
The bankers want our money NOW! And Obama is giving it to them!
Posted: March 18, 2009 3:34 AM
Well, when do we stop tapping the keyboards and start dancing on some heads?
Chat is cheap.
Posted: March 18, 2009 4:49 AM
Capitalism isn't insanity! And I don't think capitalism is the root of all the evil. But the banking system really needs to be upgraded, now it's evident to everybody.
The article is great, I've translated it into Belorussian and posted at my site, kraina.by.
Thanks.
Posted: March 18, 2009 4:59 AM
These numbers are all misleading and it is clear you don't understand how this market actually works.
While total gross positions may be this large, the net positions, summed over each counterparty are much, much smaller. This is because if you put on a large CDS position, to remove it or make it smaller, you would put on another position in the opposite direction (i.e., sell rather than buy protection). Other derivative markets work the same way.
Having said that, there is a problem with the market as currently structured. The CDS market would work fine as long as everyone collateralized their positions. Unfortunately, many of the larger firms in the market (e.g., AIG) where not required to do this by the other market participants. The government just needs to (1) Require these to not trade OTC (2) Move the market onto an exchange and (3) require firms to MTM each day and exchange colleteral. Then this wouldn't be an issue. BTW - you'd still have the big numbers you are mentioning, but again, those are gross positions which is very misleading and you are clearly confusing the people who are reading this.
Posted: March 22, 2009 12:52 PM
Derivatives aren't a part of capitalism so stop saying this is a reflection on capitalism.
You can have capitalism without all these stupid ideas attached to it.
Posted: March 23, 2009 7:27 AM
Capitalism changes all the time, it moves from crisis to crisis because crisis is an inherent quality of capitalism. Marx figured that capitalism would eventually collapse because of its inherent instability but that hasn't yet happened. It seems capitalism has the capacity to recover from each crisis then move on to test the bounds of the next crisis...
I'm amazed that economists blame prior recessions/depressions on faulty Fed/government decisions. Boom and bust cycles are a function of capitalism. Thinking that they aren't, that we can eliminate booms and busts, is ridiculous nonsense.
Posted: March 23, 2009 4:17 PM
Tom,
While I found your numbers entertaining and valuable, I have to agree with some others that they may be out of context. imho, the best analogy to many of the instruments discussed is simply gambling. When bets are placed (assessing risk) there is no tangible value until the outcome of the game. I agree that the trust factor is real, as you would want to be paid by the house. While some instruments may have underlaying assets providing value basis, the unmitigated growth and non-regulated nature of those that do not have simply created a lot of folks that can't/won't pay on their bets. And we worried about the wiseguys for how long?
Posted: March 25, 2009 6:54 AM
This is some pretty technical info, but the bottom line is the same...we've got to stop the bleeding NOW!!!
How long before we're in the abyss with no hope of return?
Get rid of the Fed...abolish taxes...bailout the average citizen directly!!!
Posted: March 28, 2009 4:39 PM
The $1.144 Trillion Worldwide Derivatives Market are dated December 2007. Is it possible to get an update with new figures for 2008 or a projected estimate for 2009? Thanks.
Manfred
Posted: August 10, 2009 3:16 PM
New update would be very helpful with additional derivative figures for 2008 & 2009 with the listing of the top 10 countries. Thanks.
Manfred
manfred5@canby.com
Posted: August 10, 2009 3:31 PM
Manfred, I will try and find some updated figures. Thanks for your interest.
Posted: August 11, 2009 12:04 PM
One must remember that derivatives are a zero sum game; always a winner and a looser, like flipping a coin or placing a bet on a roulette table. The payout ratio is irrelevant. This being the case, it matters not the size or scope of derivatives trading in the world. More individuals betting against one another for the same coin flip has no effect on the underlying asset (or coin flip). They are all merely contributing to the vig, I mean commission the brokers and intermediaries receive for facilitating the bet. Focusing on the underlying asset is the real issue.
It is when the payout ratio of a derivative is skewed or imbalanced and defaults occur that holders of the derivative on one side of the equation may get burned. Image you purchased earthquake insurance, paid into it for years, and when an earthquake hits the insurer did not evaluate their risk and had an insufficient pool of resources to pay out for the damages. Unlike insurance that is regulated and requires the ability to cover the loss, derivatives are not regulated, perhaps because there may be no sound actuarial science that properly establishes risk. This is one of the reasons their growth and popularity has increased, because the possibility through greater understanding could yield extraordinary results, a free lunch at the others sides expense. Conventional markets, like stocks, are highly efficient, and all the free lunches (aside from illegal insider trading) have been eaten. Additionally, the extreme variation of derivatives and the nature of over the counter transactions can make regulating difficult.
Posted: September 20, 2009 10:01 AM