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.