The world still has $600 trillion at risk

 

            Financial regulators are busily looking for the next crisis with a new intensity, as so many of them missed the last one before it hit them.

           As some of you have pointed out, there is still a large overhang of derivatives out there in the market. Maybe they should look again at  that.

       Sensibly run, these financial instruments help people cut their risks. Someone who has borrowed at a variable rate can protect themselves from rising interest rates. A company receiving revenues in a foreign currency can protect that money against future exchange rate losses. A business needing to buy or sell commodities as part of its activities can protect themselves against adverse  future price movements. All this is good news. Properly used, it helps stabilise things.

           Portfolio investors too can use these instrument to cut risk. If you have a lot in shares, but fear the market may have a temporary set back, you can insure yourself against it without having to liquidate all your holdings. If your shares are in good companies, but in currencies that could weaken, you can protect the value of the currency you bought to invest in them.

          So far so good. Yet at the end of 2010 there were $600 trillion of notional amounts outstanding on the full range of these derivative contracts. That is more than ten times the total value of world output. Many of these contracts are on bank balance sheets somewhere. For everyone insuring themselves against a bad movement in interest rates, currencies or commodities, there has to be someone taking the opposite view. Quite often that will be a bank.

          Some users do not want them to cut their risks, but to gear their risks. They allow institutions, funds and companies to invest in more of the underlying commodity or currency than they can afford to buy, or to go short with the potential for substantial losses if they bet the wrong way. If this gets out of control in volatile markets, one or more of the larger users could go under. Then you have the knock on effects, as contracts are unwound in a hurry and others might come unstuck.

           It is interesting that the world total at $600 trillion is still the same as at the end of 2008. Within this total credit default swaps amount to some $30 trillion. These are the contracts that pay out if a big lender like a country fails to meet its obligations to pay all the interest and capital repayments owing.

          The ability of the world to gear its positions through this large amount of liquid contracts needs careful prudential controls. Banks can be controlled through the balance sheet rules over much cash and capital they need to put behind this type of activity. Financial regulators need to ensure adequate  rules of prudence on all the big users of these instruments.

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75 Comments

  1. lifelogic
    Posted July 9, 2011 at 6:30 am | Permalink

    The danger is the huge financial incentive for banks and insurance companies to issue pieces of paper get them certified as A1 or similar and sell them to the unsuspecting. Paper is very cheap and the buyer think he has valuable insurance and everyone is happy until the music stops in volatile market conditions.

    The only solution is proper capital and regulatory control to ensure that the institutions understand the risk and have sufficient capital cover these risks. Otherwise it is all to easy for a bank of insurance company to keep financing itself – Ponzi style. Selling more and more of this paper and paying the money received out as wages and bonuses. Then using interesting valuations and accounting techniques on the balance sheet to maintain the illusion. Finally it collapses as it must. The Government must ensure that the risks are covered by an ability to pay from capital, accounted for realistically in the accounts or they must prevent them from taking the risk on. Insurance is not a new industry any company taking money in advance on a promise needs to controlled or it will often take the money and run. Insurance, banking, travel agents, builders, time shares, national insurance, governments – does not everyone know this?

    • lifelogic
      Posted July 9, 2011 at 6:32 am | Permalink

      I forgot pensions one of the biggest example of pay now get cheated later schemes.

    • lifelogic
      Posted July 9, 2011 at 7:22 am | Permalink

      It was interesting to hear Dimbleby on any questions defending the BBC after Matthew Parris pointed out the BBC was rather more influential than the Murdoch empire. “But that is financed by the licence fee payer” he said (he seemed to think that this was some sort of defence). In other words funded, not by voluntary customers, but by tax payers forced under threat of criminal prosecution. Thus receiving an unfair subsidy, in comparison to others, of £3.5 billion and the transmission airtime. Also pretty much ensuring, at the same time, that it always pushes a pro EU, pro government, big pro state agenda for ever more – regardless of the insanity of the state agenda at the time.

      Perhaps one of the most damaging organisations to UK politics and wealth ever created. BBC “think” is now alas so ingrained in millions of simple minds across the country. Poor educations systems and health and many other state bodies are safe in their dis-functional and damaging ways due to the endless supportive, there is no better alternative, BBC propaganda.

      Still I quite like some of radio 3 and radio 4 is always good just to amuse – by letting you know how these simple socialist minds think or rather “believe”.
      Radio 4 comedy or woman’s hour are often the best examples of this unfunny brainless, green, arty, big state, equality of outcome socialism but it is endemic.

      • cronshd
        Posted July 9, 2011 at 10:11 am | Permalink

        Yes – and it is amazing how difficult it is to challenge the righteousness of the BBC with most people.

        I have noted more challenge to the BBC ‘out there’ in the last 12 months and I hope more will come.

        PS Could you provide a link for the Matthew Parris – Dimbleby programme? I did not see Parris on QT last Thurs?

        • lifelogic
          Posted July 9, 2011 at 2:15 pm | Permalink

          Sorry it was “Any Questions” on radio 4 yesterday and today on bbc iplayer.

          http://www.bbc.co.uk/iplayer/console/b012942s

          • Bazman
            Posted July 9, 2011 at 6:33 pm | Permalink

            The only protection against the BBC Rays can come from a Beanie hat. This can ideally be made from tin foil, or at last gasp newspaper.

            http://en.wikipedia.org/wiki/Tin_foil_hat

          • Bazman
            Posted July 9, 2011 at 6:39 pm | Permalink

            I forgot to mention the tin foil should be shiny side out.

          • Bazman
            Posted July 9, 2011 at 6:41 pm | Permalink

            I have been drinking wine.

          • lifelogic
            Posted July 10, 2011 at 6:28 am | Permalink

            The only real protection against the BBC Rays is a mind that thinks logically for itself – rather than one that just feels with basic emotions – perhaps because they saw an emotive picture of a pretty polar bear on a lump of ice in a setting sun for example.

            But one can see (from the vast numbers who illogically throw their money away on lottery tickets or vote endlessly for more socialism or mistakenly think buses/bikes are greener than efficient cars) how few, as a proportion, do actually think with anything but their gut feeling. Guts usually give the wrong answers they are after all for digesting food not information. Advert agencies, politicians, salesmen and television programs use these emotions all the time just to con you.

            Doubtless this “emotion think” is why Cameron is off to meet the Dowlers rather than do anything useful with his time.

      • Bazman
        Posted July 9, 2011 at 10:25 am | Permalink

        You seem to have a large axe to grind with the BBC. I wonder why as you say you do not watch much TV and so must be getting your information second hand. I also wonder what you would have to say if the BBC was as bias and as bad as FOX News is for half truths and bad journalism. Hull’s chief legal officer got a 77k pay off from her 85k pa post Chief executive of Suffolk got 219k after facing an investigation into bullying and 12k on management coaching after quitting. Whist at the same time 6500 workers down to the cleaners at Shropshire will be sacked with nothing and only be rehired after a 5.4% oat cut. Got anything to say about that other than they all should have been sacked without anything. Is that the fault of the BBC, Europe, arty left wing conspiracy? Hows the ladder work?

        • lifelogic
          Posted July 9, 2011 at 11:26 am | Permalink

          If these 6500 people were sacked they have to have done something serious and worthy of sacking or else they can make a claim. It they were made redundant then they get a pay off and notice.

          My BBC info comes mainly from radio 3/4, the news and Newsnight, Question time and the like: where the agenda of a big state, quack greenery, equality of outcome (regardless of merit), over regulation, anti business, scientific and statistical ignorance and pro EU stance is always very much in evidence.

          Their coverage on radio 3 of the Aldeburgh festival is usually very good though as is much else on radio 3 and the occasional thing on radio 4.

          • Bazman
            Posted July 9, 2011 at 6:22 pm | Permalink

            And the ladder work?

        • forthurst
          Posted July 9, 2011 at 1:41 pm | Permalink

          “I also wonder what you would have to say if the BBC was as bias and as bad as FOX News is for half truths and bad journalism.”

          It is and, furthermore, FOX is not, unlike the BBC, under any obligation to offer a fair and balanced view. What people object to is not so much the point of view of the BBC, entirely contrary to its Charter as it is, but the fact that we are obliged to pay for it.

          In point of fact both give a deliberately distorted view which sometimes coincides and sometimes is opposed, but they are both lying most of the time by commission and, more importantly, omission: a Punch and Judy show for cretins.

          • rose
            Posted July 9, 2011 at 5:07 pm | Permalink

            And both are republicans, anti-elitists, secularists, vulgarians, partisan pedlars of untruths… they have almost as much in common as Hitler and Stalin.

          • rose
            Posted July 9, 2011 at 5:13 pm | Permalink

            Except that the religious broadcasting on the BBC has been infiltrated recently by an alien and distinctly unsecular presence.

          • Bazman
            Posted July 9, 2011 at 6:25 pm | Permalink

            No it is not and you are obliged to pay for SKY.

          • APL
            Posted July 11, 2011 at 7:45 pm | Permalink

            Bazman: “No it is not and you are obliged to pay for SKY.”

            Well of course you are obliged to pay for SKY, but only if you want to watch it.

            Now if you want to watch SKY but not the BBC and refuse to pay the BBC license fee* the whole might of the state comes down upon your head.

            * a license for a consumer good. Imagine being forced under pain of imprisonment to pay a license for your refrigerator.

      • Caterpillar
        Posted July 9, 2011 at 10:42 am | Permalink

        My thought for today:-

        The ‘Today Programme’ is often seems to be one of the funniest comic programmes put out by the BBC; how many years until ‘we’ get the joke?

        • lifelogic
          Posted July 9, 2011 at 11:33 am | Permalink

          Indeed always funny to see how ever situation is always framed and contrived to fit into the BBC “think” mold.

  2. Javelin
    Posted July 9, 2011 at 6:31 am | Permalink

    I looked after Credit Default Swaps at HSBC during the crash. I cant say anything about their positions – but can say they didn’t harm them. They didn’t take on mortgage backed bonds and only got hit for a few years buying the US mortgage brokers Household – whose staff acted like double glazing salesmen. HSBC were a well run bank in the centervwith a good banking ethic. The other banks seemed to be put profit above risk. I still think naked short a CDSwaps are illegal under the 1774 Life Assurance Act – the Act is clear and short and still in effect.

    You’re absolutely right that some derivatives are the problem. I still believe Italian banks will bring the Euro down. In the CDSwaps market a huge number of CDSwaps have been taken out insuring against Italian banks – more than any other banking sector. I’m not sure if that is published. Derivatives have hidden our debts and risks from all of us, including politicians. But risks are like water you cannot hide them.

    You can financially engineer situations so that risks become highly geared – so huge losses come quickly and without fanfare. Of course the warning signs are all there but derivatives hush them up and politicians only oil the squeaky wheels. I think that is what is key about derivatives – they change the profile of the products. They allow debts to go off balance sheet, to be deferred, to swap short term small potential losses for large ones in the long term via risk transfer.

    Our debts get kicked down the road. Whilst huge pensions are promised to the public sector well new students run up debt. This is a good example of how debts are kicked
    down the road. I think going straight into a public sector job from school and getting promoted is a better option than Uni and staying as an engineer on the ground floor.

    • Javelin
      Posted July 9, 2011 at 6:40 am | Permalink

      Just wanted to add. Listening to Trichet on Thursday I think the leaders in Europe have lost the plot. There is an undemocratic psychosis (unelected denial) in the heart of Europe. A denial that many contries are insolvent. Central bankers are playing at Investment Bankers are trying to financially engineer an exit route – where none exists. Risk profiles are being engineered to swap financial stability for political risk – by that I mean it is going to become very easy for a small politically driven financial event to destroy a large economic structure.

      • forthurst
        Posted July 9, 2011 at 12:22 pm | Permalink

        It would be indeed surprising if it were legal to insure against the potential for a third party’s loss. The problem, nevertheless is that banksters believe that they are entitled to invent derivative instruments however unethical or potentially dangerous in order to generate income and plug holes in their theoretical models of risk.

        I recall you complaining about the possibility that those accepting a Greek default risk would not ultimately pay up because they didn’t have the wherewithal. It now emerges that the US Treasury has attempted to intervene to protect their banks’ CDS postions by trying to influence the Greek debt outcome. Am I the only person who thinks that trying to offload US banks’ risk on British taxpayers is unacceptable? Has anything that has been done by banksters and polticians recently in conspiring together to socialise the debts incurred by those whose actvities have no social value been either acceptable or fair?

        It now transpires that cash paid out by US taxpayers to refloat a bankrupt Insurance co in 2008 went straight into a (company’s-ed) proprietary a/c. These (people-ed) are perverting and undermining Capitalism.

        We need to be protected against banksters rather than be required to underwrite their entirely undeserved lifestyles by accepting the consequences of their failed bets.

    • Gary
      Posted July 9, 2011 at 10:06 am | Permalink

      By many accounts interest rate swaps outstanding dwarf CDS outstanding. These have distorted rates, and may have been used as instruments to deliberately suppress rates. In any case , the most optimistic guess is still many multiples larger than the ability of the global economy to cover.

    • Simon
      Posted July 9, 2011 at 10:58 am | Permalink

      Insurance policies are typically on either a risks attached during or losses occuring during basis .

      Are these synthetic CDS on a risks attached during basis and when do they eventually expire ?

      Could they be cancelled with a return of premium ?

      Given the hole we are in , one would have thought that the first thing to do was adopt the cautious approach and stop digging . Can you see any reason not to prohibit the practice of shorting and outlawing synthetic CDSwaps ?

      Quote …. “I think that is what is key about derivatives – they change the profile of the products. They allow debts to go off balance sheet, to be deferred, to swap short term small potential losses for large ones in the long term via risk transfer.” ….nicely explained .

      • norman
        Posted July 9, 2011 at 3:50 pm | Permalink

        “I think that is what is key about derivatives – they change the profile of the products. They allow debts to go off balance sheet, to be deferred, to swap short term small potential losses for large ones in the long term via risk transfer.”

        At last I understand CDS – it’s PFI on steroids!

        Good job the Tories, so against PFI when in opposition, have done something about them and stopped using them.

        Oh, wait…..

        Surely we can blame the inaction on that on the Lib Dems or the EU?

  3. Mike Stallard
    Posted July 9, 2011 at 6:49 am | Permalink

    I am getting the impression that money is out of control.

    Our own national debt is a trillion pounds. That looks like this: £1,000,000. Except that, every pound is in itself a million pounds. We are not doing money but astronomy! Me, I think a tenner is a luxury item. Apparently USA’s debt is approaching their GDP which is something like 14 trillion. And we are the healthy ones!

    What is becoming very obvious to me is that the State is no longer able to cope with the bankers. All this regulation seems to me to be to appease people like me who need reassurance that everything is wonderful.

    Even the USA, the richest country, apparently, in the world, cannot afford to cover a tenth of the vast amount of derivatives (and, let’s face it, as bets they are just that) which you are talking about.

    We need to be very canny and not depend on the State.

    • Damien
      Posted July 9, 2011 at 10:07 am | Permalink

      I think a trillion has 12 zeros, one million x million

    • Caterpillar
      Posted July 9, 2011 at 10:54 am | Permalink

      I do think per capita numbers help to put things into perspective, but unfortunately lead to complexity. The £10^12 you mention is about £30,000 per worker or £15,000 per person. It should be manageable if the Govt gets a grip, the danger is that the ZIRP/QE policy of the MPC can become a trap – at some point a country can not afford to get out of the ZIRP/QE policy. Japan got stuck in, US is finding it doesn’t work, yet the MPC continues each step of the play; believing too late for tightening is better, not worrying about the central bank and continuing to hype deflation. A flawless execution of a dangerous academic experiment.

      • Mike Stallard
        Posted July 9, 2011 at 5:50 pm | Permalink

        I have just been studying John Law 1722 in France. As a brilliant Scottish Economist (but not as good as Mr Brown) he foresaw that the future was printing money, as much as possible.
        Not only did he ruin a lot of people, he also brought on the French Revolution some 70 or so years later, as France never really recovered.

        • StevenL
          Posted July 9, 2011 at 11:02 pm | Permalink

          The John Law story is a good one isn’t it? A dodgy Scotsman handed control over a foreign nations purse strings, only to monumentally wreck said nation.

          Parallels can indeed be drawn with a certain other Scotsman.

    • rose
      Posted July 9, 2011 at 5:40 pm | Permalink

      I thought 1,000,000 was still a million, and that the Americans had debased the value of billions and trillions. I don’t know what they are now. Less than they used to be, and less than this inflationary world needs to describe itself.

      • rose
        Posted July 9, 2011 at 5:46 pm | Permalink

        A billion used to be: 1,000,000,000,000 (one million million), and a trillion:
        1,000,000,000,000,000,000 (one million million million).

        • alan jutson
          Posted July 9, 2011 at 11:31 pm | Permalink

          Rose

          Your example is exactly why figures should always be in figures not words, figures should have and give a greater impact of their size.

  4. Stuart Fairney
    Posted July 9, 2011 at 7:15 am | Permalink

    “That is more than ten times the total value of world output”

    Anyone still think fiat currency is a good idea or that governments can be trusted to run them via their central banks?

    No me neither. Odd then you don’t hear anything of this from any of the parties. It’s almost like they want the power to counterfeit at will, cause inflation and steal from you covertly.

    • Simon
      Posted July 9, 2011 at 11:02 am | Permalink

      They clearly see it as an advantage . It enables them to disguise the true situation and carry on regardless – business as usual .

      If we had sound money without the ability to extend credit indefinitely without limit we would never have got into this mess .

      Better they steal it from us than the next generation I suppose …. er hang on

  5. Alison Granger
    Posted July 9, 2011 at 8:33 am | Permalink

    How are government regulators with a proven record of failing to prevent any problem going to regulate extremely complex, cross border, off the books, financial instruments that almost nobody fully understands?
    For governments to continually suggest that they can control and regulate our way out of financial disaster is ridiculous and misleading when they quite clearly cannot be trusted to manage even their own office budgets. Politicians should stop trying to impress voters with their brilliance and just manage basic services leaving real free markets to manage themselves. If that happened investors would be much more careful how they managed their funds and taxpayers wouldn’t be on the hook for trillions of pounds of debt that they had no say in spending.

    • Bazman
      Posted July 9, 2011 at 10:28 am | Permalink

      Thats exactly what they did with the banks and look what happened? To much regulation. Governments fault for letting then do what they like say the banks. Get real.

      • lifelogic
        Posted July 10, 2011 at 10:21 pm | Permalink

        There is good sensible regulation and bad counter productive regulation – no one is saying that no regulation is needed at all.

  6. Alan
    Posted July 9, 2011 at 9:26 am | Permalink

    I think you are right to publicise the dangers that exist in our financial system. They are very real, but it is difficult to know how to limit them. The capitalist system is successful because it encourages people to take risks to make money. It provides penalties for those who fail in the form of losing money. But there are plenty of people for whom the potential gains (which can be very large) will always outweigh the potential losses. If we pass laws against people making gains that others regard as excessive we may well end up with an economy that does not develop. There would be less wealth to go round at a time when it is clear that there is far too much poverty.

    I suspect we have to tolerate the occasional financial crisis if we want this country and the world in general to be richer. We should work to prevent specific problems that we see coming but we have to accept that crises will still occur. The most relevant and practical thing we can do is to find ways to mitigate the inevitable damage. Looking back at the origins of the current crisis, for example, we can see that we should have had systems that would have allowed ordinary people to make cash withdrawals and other transactions for ordinary purposes even if the banks failed. We came very close to halting the entire financial system in such a way that many people could not even have gone to the supermarket for the weekly shopping.

  7. Acorn
    Posted July 9, 2011 at 9:38 am | Permalink

    Many of these exotic derivative products play no part in the efficient deployment of investment capital; they are simply gambling. “Naked” and “synthetic” products have no constructive investment purpose and no social benefit.

    I think Mr Soros called it correctly. His explanation of how the “asymmetry of risk” was massively amplified by CDS products being traded for profit and treated like warrants.
    http://online.wsj.com/article/SB123785310594719693.html

  8. Gary
    Posted July 9, 2011 at 9:50 am | Permalink

    The notional value outstanding may be much higher, even double.

    We have regulators, but they are lying. They tested some derivatives in the market in 2008 and they were worth almost nothing. The markets collapsed. So they turned around in a panic and said the banks could value them on their books at whatever value they want. Meanwhile the central banks started buying them at full face value. Ie a taxpayer funded stealth bailout, on top of TARP , was initiated.

    This continues until today. No problem has been solved, the problem merely got kicked down the road and magnified.

    This is what happens in a fiat fractional reserve pyramid system. When you pyramid loans beyond your reserves for only a few cycles you soon run out of debtors, then you have to resort to derivative securitization.

    The answer is to abolish fiat legal tender, let the market chose the currency and this will drive out unsound money. No one with his senses would accept inflating unsustainable money as payment unless they were forced to by legal tender laws.

    If people want to hedge under sound money, there is nothing wrong with using fully funded insurance. Leveraged derivatives will be shunned.

    This system is bankrupt, the books are cooked, we have just not realized it yet. Throwing more money at it is a complete waste of time. Stop the bailouts, mark the books to market, let the bankrupt fail and get a sound currency. It will be enormously painful but we are where we are. This won’t happen because politicians are busy bribing voters with fresh loans as we speak.

  9. Gary
    Posted July 9, 2011 at 10:13 am | Permalink

    Make that “when you pyramid loans beyond your deposits”

  10. Gary
    Posted July 9, 2011 at 10:20 am | Permalink

    Gresham’s Law, where unsound money drives out sound money, only applies under legal tender laws ie when then govt enforces use of unsound money. Under a free market there is no advantage accepting payment in unsound money, so under a free market good money drives out bad.

    • Mark
      Posted July 9, 2011 at 12:26 pm | Permalink

      Gresham’s Law simply points out that people will hoard a valuable currency and use the weak one for payment. It becomes a game of pass the parcel that robs anyone who holds it, as someone must, until it become valueless – i.e. no longer a means of payment or so hyperinflated as to be worthless.

  11. Nick
    Posted July 9, 2011 at 10:32 am | Permalink

    The next one in the UK is the FOS and the FSA.

    Banks are selling investment products and misstating the return on the bonds. They have used the wrong calculations, and its deceives the buyer into thinking they have a higher return than they actually have.

    The FSA agree that this is the case, but won’t do anything about it.

    Likewise with the FOS.

  12. oldtimer
    Posted July 9, 2011 at 10:32 am | Permalink

    One of the leading articles in The Economist this week is about the subject of debt reduction and is entitled “Handle with care”. It starts out with a bar chart for total debt as a % of GDP as at Q4 2010. Britain leads the world (again!) with c500%, followed by Spain c360%, France c340%, USA c290% and Germany c280%. It appears they include the sum of consumer, business and government debt in their calculation. It seems to me that the derivative risks you identify are on top of the conventional hazards of the excessive debt identified by The Economist.

    It notes the four ways this conventional debt is dealt with in various degrees of combination – thrift, growth, inflation and default. Of course taxation, along with inflation, is the preferred method of the UK government for dealing with the problem but that merely transfers the burden onto consumers and businesses and is not, in the national context, a solution at all. In addition the UK government is burdening us all with the uneconomic costs and devastating consequences of its Carbon Plan, designed to implement the Climate Change Act.

    The outlook is extremely bleak and hazardous. So far, it seems to me, the UK`s political leadership has failed to communicate the depths of the problems we face or to implement the policies that will extricate us from the hole we are in. We are, it appears, still digging.

  13. StrngholdBarricades
    Posted July 9, 2011 at 10:41 am | Permalink

    What happens if we pull the plug on this avarice?

    • StevenL
      Posted July 9, 2011 at 11:06 pm | Permalink

      Everything blows up (financially speaking) I expect.

  14. Damien
    Posted July 9, 2011 at 10:52 am | Permalink

    Next Friday we will have the publication of the enhanced bank stress tests, albeit without any actuarial consideration of the under the counter derivatives and Chernobyl debt obligations. Those banks who fail the tests will have three months to make a plan and three months to implement it, a life time in other words. Failing banks will then have to be bailed out by the respective governments. We thought that it was agreed that failing banks would no longer be bailed out by taxpayers but apparently that never has and never will be the case !.

    So much for Trichet raising interest rates; the euro fell by 1 per cent a day later. Germany still wants bondholders to take a haircut (as do most ordinary taxpayers) and Italy is about to lose its finance minister (and the bond vigilantes smell blood). Throw in the results of the bank stress tests and crisis becomes ‘the new normal’. The impact of the IEA releasing reserves to lower the oil price didn’t last long, Friday’s Brent Crude hit $118 once again.

  15. Caterpillar
    Posted July 9, 2011 at 11:06 am | Permalink

    Given that notional amount outstanding is recognised a measure of structure and not of risk, and I read elsewhere that actaully credit exposure is around a percent or less of notional amount outstanding, could on of the financial gurus out there tell me how to interpret JR’s big number?

    Reply: The value of these instruments is a lot lower than the notional amount outstanding, but still a large sum – gross market values are around $20 trillion.

    • Caterpillar
      Posted July 9, 2011 at 5:09 pm | Permalink

      Thank you.

      So about a third of world GDP market value for instruments that (hopefully) act to price risk and so help to provide liquidity. Again I am naive, this doesn’t sound too bad. Is the extent of gearing known?

  16. Duyfken
    Posted July 9, 2011 at 11:39 am | Permalink

    This reminds me so much of the disaster which befell the London insurance market some decades ago. The business was called London Market Excess and consisted of trading risks, first by assuming liabilities and then laying them off. However the market for such business was limited and (re)insurers found themselves trading with the same risks time and time again in what may be likened to a game of pass-the-parcel, or in a “spiral” as it was loosely termed. The result was that the aggregate liabilities mounted to astronomical, but artificial, levels. Whereas the value of original insurance risks may have totalled say some tens of millions, the spiral produced aggregates in the hundreds of millions or more. The whole structure was unsound (as should have been realised by the market practitioners) and after a bad run of original loss events, it collapsed with disastrous consequences to Lloyd’s and others.

    I speculate that the quoted $600 trillion at risk in the financial markets is similarly overstated, but when the inevitable event occurs to burst the bubble, there will be many falling over like dominoes (to mix metaphors), just as happened to the insurance market.

    The lesson to be learned but so often forgotten is to keep it simple and in the case 0f derivatives keep to the necessary minimum for protection, rather than using them as a tool to leverage greater profits.

    • Mike Stallard
      Posted July 9, 2011 at 6:00 pm | Permalink

      On a personal note, I would like to say that I had the privilege of teaching a girl whose parents had crashed with Lloyd’s. She was thrown out of her private school and came to us. She eventually got her A levels with honour and went on to University.
      But her life had been blighted at its most vulnerable age.

  17. Bazman
    Posted July 9, 2011 at 11:58 am | Permalink

    What is at risk? Money to made from destruction and money to be made from rebuilding would be the view of the markets.

  18. Lindsay McDougall
    Posted July 9, 2011 at 12:27 pm | Permalink

    So which banks have potential liabilities that exceed their assets?

  19. Gary
    Posted July 9, 2011 at 12:57 pm | Permalink

    When a counter party defaults the notional amount tends to the actual. Since derivatives are not subject to the market , we must assume that their balance sheet value is overstated, which would make many companies solvency overstated, which in turn would make the ACTUAL outstanding derivative risk closer to the NOTIONAL.

    In a systemic collapse the ACTUAL=NOTIONAL. ie there is no market for the derivatives and derivative insurance defaults. This is probably why even small countries are not allowed to default , fearing that could lead to a domino or systemic collapse.

  20. APL
    Posted July 9, 2011 at 1:58 pm | Permalink

    JR: “As some of you have pointed out, there is still a large overhang of derivatives out there in the market. ”

    A simple solution. All derivatives in UK juristiction should be forced onto an exchange, daily collateral posted for each counterparty.

    If a counterparty cannot demonstrate its ability to settle its contractual obligation then that counterparty entered the contract on a false pretense and the contract should be nullified.

    Many of these derivatives contracts are nothing less than pure gambling.

    • sm
      Posted July 9, 2011 at 6:09 pm | Permalink

      Derivatives: A Capital Markets Gong Show For Whom The Bell Tolls
      http://www.marketoracle.co.uk/Article29005.html

      Not sure its just a UK jurisdiction problem. Perhaps they should be all netted out by law on an exchange- so the risk can be managed down to a level not likely to call on taxpayer funds/fixes. However is it possible that some governments may be using these contracts for short term political purposes?

      Another reason for complete legal seperation, narrow banking remits etc.

      • APL
        Posted July 9, 2011 at 11:48 pm | Permalink

        SM: “Not sure its just a UK jurisdiction problem.”

        No it’s not, but the UK government only has jurisdiction in the UK legal area.

        For those who might be tempted to suggest this is a role for the EU, they are busy denying the Euro area banks are insolvent and blaming the rating agencies for, for once, telling it like it is!

  21. norman
    Posted July 9, 2011 at 3:58 pm | Permalink

    Why are we, collectively, allowed to insure against failure on such a scale? Surely the main thing capitalism (free market capitalism, not the crony capitalism – politicians in league with large corporations rigging the game – we have seen for the last generation and which has brought us the credit crunch amongst other delights) has going for it is that ventures can fail and attract losses, so we are careful where to invest in the first place, or when we are involved in a failure, like natural selection, we wise up so as not to get our fingers burnt in the future.

    Insuring on such a colossal scale seems counter intuitive to my simple brain.

    We really have lost the plot.

  22. Mark Wadsworth
    Posted July 9, 2011 at 4:23 pm | Permalink

    Big deal. We can solve this problem at a stroke by saying that debts arising from these derivative contracts have the same legal status as gambling debts – while not illegal, they would simply not be enforceable in a court of law. For sure, if people paid for the insurance, the insurance provider would have to repay the premium, apart from that, problem solved.

    • Fred Bloggs
      Posted July 12, 2011 at 10:10 am | Permalink

      Why is a derivative contract any different from your house or car insurance ?Surely the insurance company is “gambling” on the cost of car accidents being less than the total premium received across some large pool. Perhaps when you crash they simply give you back your premium. Problem solved for them but not for you.

  23. Suze Doughty
    Posted July 9, 2011 at 4:25 pm | Permalink

    So there is still more money owed than there is to have lent? I think you are right and that is why my instinct is never to leave money in a British bank, or any bank. If you got it, lend it.

  24. Electro-Kevin
    Posted July 9, 2011 at 6:27 pm | Permalink

    A global economic crisis and our PM is on the racks already, in deep trouble and unable to do his job.

    He brought it all upon himself. Please don’t let him get away with closing down the only democratic outlet we have left – the tabloid press.

    David Cameron = Tony Blair but without the style or the guile. He’s not worth sacrificing one newspaper editorial over. I bitterly regret voting for him and I don’t know how you can continue to serve under him.

    • APL
      Posted July 9, 2011 at 11:54 pm | Permalink

      Electro-Kevin: ” … and unable to do his job.”

      His [the british prime minister] job is to pretend he is in charge of the governance of the UK while knowing he is just a muppet puppet.

      tch, careless spelling there.

      Electro-Kevin: “.. I don’t know how you can continue to serve under him.”

      Party before country. Mr Redwood proudly boasts of voting for Cameron to lead the Tory party.

  25. alan jutson
    Posted July 9, 2011 at 7:07 pm | Permalink

    Just a very simple thought.

    I wonder if the world would be a more settled place (financially) if you were not allowed to insure or pass on risk at all , but had to be responsible and suffer the financial consequenses of your actions, and simply not be able to pass it on at any cost.

    Would it curtail some of the more risky behaviour.
    Would we all act in a more risk averse manner.
    Would it stop the casino type investment gambles by banks, knowing they would suffer the losses direct.
    Would it stop gambling on futures when you could not set off the risk.
    It would certainly stop pieces of paper going around with dodgy values.
    But would it help us to get back to sound money.

    Any thoughts anyone, or am I being a simpleton ?

    • Fred Bloggs
      Posted July 12, 2011 at 10:05 am | Permalink

      Nope. If I cannot buy health/car/property insurance then the world would be a much less settled place for me. If I was a bank, then the ability to use interest rate swaps to swap my fixed rate income from my bond holdings for the floating coupons I need to pay depositors gets rid of an interest rate risk that I had.

      As long as the cost of the insurance reflects the risk, then the system should work well. Of course we need to police the system to stop people from cheating and we need to ensure that insurance companies and derivative dealers/CCPs have sufficient reserves.

      Also, what is this comment about pieces of paper going round with dodgy values? Perhaps you can be specific. Making a statement like that requires some sort of facts to back it up.

      Also, this has nothing to do with sound money. Derivatives do not create money. They are not inflationary. Let’s not get sidetracked.

  26. StevenL
    Posted July 9, 2011 at 11:05 pm | Permalink

    Over at zerohedge they have been questionning whether certan US banks coul handle interest rate rises or whether their interest rate swaps books would blow up.

    I’m sceptical about what I read over there, but the have been rigt about a few things.

  27. simple soul
    Posted July 9, 2011 at 11:19 pm | Permalink

    Are you including in your figures the very large speculative positions, both short and long, in gold, oil, and copper?

  28. simple soul
    Posted July 9, 2011 at 11:23 pm | Permalink

    Do you broadly agree with last week’s PWC report which argued that as regards our debt to GDP ratio, the UK is going the way of Greece, even if in slow motion?

  29. simple soul
    Posted July 9, 2011 at 11:27 pm | Permalink

    Don’t you find the business mood as expressed by indiviual firms is remarkably cheerful considering the big economic and financial picture? Isn’t there some contradiction here?

  30. Kaspar Stuart
    Posted July 10, 2011 at 1:29 am | Permalink

    It has all happened before, and is not a mystery – although perhaps in a different market. The world’s deeply entrenched derivatives disease is a replay of the Lloyd’s insurance market’s LMX Spiral- whereby risks leaving the front door of insurers came in through the back door without anyone realising it . And look what that did, and the time and measures it took to remedy.
    The lack of transparency of outstanding derivative risk is part and parcel of “Over The Counter “culture which stole a march on Exchange Traded Instrument culture from the 1990’s onwards. If these instruments were exchange listed then the ‘outstanding’ derivative contracts compared to the ‘underlying’ would be manageable – and possibly rather useful. The disintermediation of official markets must be the responsibility of central, rather than commercial or investment bankers – even though they might have been asleep or otherwise engaged at the wheel at the time.
    The ethical imperative as well as the market issues, is not to routinely separate the granting of credit and the resulting loan book. Most consumers believe and would prefer a loan book stays with the people who generated it.

    Another subject which I inwardly riot about and have to deal with every day is the absence of hostility toward the European Central Bank in Europe, or any movement to institutional reform. How many very highly paid (with taxes) people does it really take to not be able to predict a Greek sovereign debt crisis?

  31. Gary
    Posted July 10, 2011 at 10:06 am | Permalink

    Prof Steve Keen, who predicted and has so far been correct about every aspect of this financial crisis, gives a lucid, apolitical explanation of the debt picture. He states the fact that although the USA has a total debt now of about 270% of GDP(down from about 300% three years ago), that is still 140% higher than the total debt bubble going into the Great Depression. Given that the UK’s total debt is still over 450% of GDP, and if you accept that the bust is at least proportional to the size of the debt bubble, we must have reason to be very concerned. The derivatives outstanding may or may not even be accounted for in these sums. The banks core profits come from issuing debt. Creating asset bubbles is a effective vehicle for creating demand for debt. When the risk of creating the debt is removed from the banks and placed onto the taxpayers, then there zero incentive for the banks to hold back. That is the seed of the crisis.

  32. Fred Bloggs
    Posted July 11, 2011 at 11:21 pm | Permalink

    I am a finance prof and ex-city derivatives specialist.

    It is true that the size of the derivatives market and especially that of the interest rate swap market is huge when you simply sum the notional of all trades (each trade is a bilateral contract between party A and B).

    However, many and perhaps a majority of these trades are actually back to back trades in which say a fund A enters into a swap with a bank dealer B. Later A wants to unwind the trade (before it matures) with B but does not like the price offered by B. He finds a better price with C and so creates an offsetting position with C and in doing so locks in a profit. Investor A has no further risk to the swap as long as B and C can pay the cashflows. Also, bank B and bank C will also have hedged the position using offsetting trades. They too will have no risk (as long as their counterparts can pay the promised flows).

    At the end of the day, every trade spawns a chain of trades and only the ones at the ends of the chain are exposed to the underlying risk. These are people who actually want to hold the risk. In the case of interest rate swaps this would mean that someone who wants to receive Libor and pay fixed sits at one end of the chain and someone who wants to pay Libor and receive fixed sits at the other end.

    The main risk is not the interest rate risk of the swaps but is one in which a large market counterparty e.g. a large dealer, defaults. But even this can be contained using the posting of collateral or the use of centralised counterparties (CCPs).

    Bottom line is that the numbers quoted above are not commensurate with the actual risk. However that is not so say that all is fine and dandy. What we need is greater transparency about who is at the end of the aforementioned “chains”. This information needs to be visible to regulators who can monitor it and require measures to be taken (netting off of trades using market compression tools or an increase in collateral posting requirements).

    Reply: Thank you for a considered response. I explained that I was quoting gross exposures, and that some of these are risk reducing. As you say, some are held to cancel others. There is counter party risk, which could make “matching” exposures unstable.

    • Fred Bloggs
      Posted July 12, 2011 at 8:18 am | Permalink

      Actually I had no real disagreement with your comments. However these are complicated issues requiring a knowledge of the details and on the blogosphere there is often a great deal of misunderstanding and astonishment as such large numbers get bandied about.

      My comment is therefore aimed more at your readership and is intended to shed some light on why these numbers are so big, and to explain that the market has done and is doing things to alleviate any associated risks.

      Remember that for every buyer of a derivative there is a seller. So all derivatives do is move the risk around – they do not create a new risk (well strictly speaking they create counterparty risk but that can be minimised by collateral posting or use of exchanges and CCPs).

      Just to add a specific datapoint. If you return to the Lehman bankruptcy, just before the settlement of the Lehman-linked CDS, many punters were forecasting a disaster because of “systemic risk” and “entanglement”. However these forecasters did not understand the market. What happened was that dealers got together and simply went through the process of netting off all of the offsetting positions – a compression process. “Chains” of several trades were compressed to just two or three trades.

      Also the auction and settlement procedure used in the CDS market has since around 2005 been redesigned to allow a choice of cash and physical settlement. These actions meant that the settlement of the billions of dollars of Lehman CDS was in fact a smooth process (and a damp squib!).

  • About John Redwood


    John Redwood won a free place at Kent College, Canterbury, and graduated from Magdalen College Oxford. He is a Distinguished fellow of All Souls, Oxford. A businessman by background, he has set up an investment management business, was both executive and non executive chairman of a quoted industrial PLC, and chaired a manufacturing company with factories in Birmingham, Chicago, India and China. He is the MP for Wokingham, first elected in 1987.

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