Skip to comments.Derivatives: The Big Banks' Quadrillion-Dollar Financial Casino
Posted on 12/15/2010 11:58:59 AM PST by SeekAndFind
If you took an opinion poll and asked Americans what they considered the biggest threat to the world economy to be, how many of them do you think would give "derivatives" as an answer? But the truth is that derivatives were at the heart of the financial crisis of 2007 and 2008, and whenever the next financial crisis happens, derivatives will undoubtedly play a huge role once again.
So exactly what are "derivatives"? Well, derivatives are basically financial instruments whose value depends upon or is derived from the price of something else. A derivative has no underlying value of its own. It is essentially a side bet. Today, the world financial system has been turned into a giant casino where bets are made on just about anything you can possibly imagine, and the major Wall Street banks make a ton of money from it. The system is largely unregulated (the new "Wall Street reform" law will only change this slightly) and it is totally dominated by the big international banks.
Nobody knows for certain how large the worldwide derivatives market is, but most estimates usually put the notional value of it somewhere over a quadrillion dollars. If that is accurate, that means that the worldwide derivatives market is 20 times larger than the GDP of the entire world.
It is hard to even conceive of $1,000,000,000,000,000. Counting at one dollar per second, it would take you 32 million years to count to one quadrillion.
So who controls this unbelievably gigantic financial casino? Would it surprise you to learn that it's the big international banks?
The New York Times has just published an article entitled "A Secretive Banking Elite Rules Trading in Derivatives." Shockingly, the paper has exposed the steel-fisted control that the big Wall Street banks exert over the trading of derivatives. Just consider the following excerpt:
On the third Wednesday of every month, the nine members of an elite Wall Street society gather in Midtown Manhattan.
The men share a common goal: to protect the interests of big banks in the vast market for derivatives, one of the most profitable — and controversial — fields in finance. They also share a common secret: The details of their meetings, even their identities, have been strictly confidential.
Does that sound shady or what?
In fact, it wouldn't be stretching things to say that these meetings sound very much like a conspiracy.
Why does it seem like all financial roads eventually lead back to these monolithic financial institutions?
The highly touted "Wall Street reform" law that was recently passed will implement some very small changes in how derivatives are traded, but these giant Wall Street banks are pushing back hard against even those, as the article notes:
"The revenue these dealers make on derivatives is very large and so the incentive they have to protect those revenues is extremely large,” said Darrell Duffie, a professor at the Graduate School of Business at Stanford University, who studied the derivatives market earlier this year with Federal Reserve researchers. “It will be hard for the dealers to keep their market share if everybody who can prove their creditworthiness is allowed into the clearinghouses. So they are making arguments that others shouldn’t be allowed in."
So why should we be so concerned about all of this? Well, because the truth is that derivatives could end up crashing the entire global financial system.
In fact, the danger that we face from derivatives is so great that Warren Buffett once referred to them as "financial weapons of mass destruction."
Most Americans don't realize it, but derivatives played a major role in the financial crisis of 2007 and 2008.
Do you remember how AIG was constantly in the news for a while there?
Well, they weren't in financial trouble because they had written a bunch of bad insurance policies.
What had happened is that a subsidiary of AIG had lost more than $18 billion on Credit Default Swaps (derivatives) it had written, and additional losses from derivatives were on the way which could have caused the complete collapse of the insurance giant.
So the U.S. government stepped in and bailed them out -- all at U.S. taxpayer expense of course.
As the recent debate over Wall Street reform demonstrated, the sad reality is that the U.S. Congress is never going to step in and seriously regulate derivatives. That means that a quadrillion dollar derivatives bubble is going to perpetually hang over the U.S. economy until the day that it inevitably bursts.
Once it does, there will not be enough money in the entire world to fix it.
Meanwhile, the big international banks will continue to run the largest casino that the world has ever seen. Trillions of dollars will continue to spin around at an increasingly dizzying pace until the day when a disruption to the global economy comes along that is serious enough to crash the entire thing.
The worldwide derivatives market is based primarily on credit, and it is now approximately 10 times larger than it was back in the late '90s. There has never been anything quite like it in the history of the world.
So what in the world is going to happen when this thing implodes? Are U.S. taxpayers going to be expected to pick up the pieces once again? Is the Federal Reserve just going to zap tens of trillions or hundreds of trillions of dollars into existence to bail everyone out?
If you want one sign to watch for that will indicate when an economic collapse is really starting to happen, then watch the derivatives market. When derivatives implode, it will be time to duck and cover. A really bad derivatives crash would essentially be similar to dropping a nuke on the entire global financial system. Let us hope that it does not happen any time soon -- but let us also be ready for when it does.
Michael T. Snyder is a graduate of the McIntire School of Commerce at the University of Virginia and has two law degrees from the University of Florida. He is an attorney that has worked for some of the largest and most prominent law firms in Washington D.C. and who now resides outside of Seattle, Washington.
It is important to understand what is meant by ‘notional value’.
For example, if I bet you $1 that the Dow will go up tomorrow, the notional value of that derivative is the dollar volume of all the Dow stocks traded tomorrow. However, the most I can gain or lose is still $1.
The derivatives market is a quasi-insurance market that the members use to hedge their paper trading. As long as defaults or bad investments are held to manageable quantity, then there shouldn’t be an implosion but that’s an assumption.
Reputable financial reseachers and analysts should be called into a task force to answer many questions on the stability of the derivatives market, the fallback positions in the event of a crisis, the pathways to implosion and the safeguards against those pathways progressing. Likely none of this has been done as it would call for regulation of an unregulated market.
Greenspan correctly assumed that free markets are perfect but in his ivory tower of Fedville he assumed that free market meant unregulated market and he did not bother to fully grasp that any market is never purely ‘free’; witness the oligarchy of interests in the derivatives market of this article. If membership is restricted, the market cannot be considered ‘free’.
But Greenspan and other political persons such as Graham took the ‘ideals’ of Reagan, one of which is the notion of a ‘free market’, and they used then to bar any oversight when in fact they were acting as gatekeepers to a very select club.
The derivative game needs referees because its failure can ruin tens of millions if not hundreds of millions of people.
The unregulated derivatives market was estimated to be $595 trillion a little over ten years ago when Greenspan and others shut out the CFTC from taking a look at its dangers for the purported purpose of preserving ‘free markets unhindered by government scrutiny’.
I loved Reagan but I also love justice. And I am sure if Ronald Reagan were alive today and in power he would have had a taskforce to deal with these dangers and also prosecute fraud. Because I would bet that behind the clearinghouse of the big banks are mechanisms to rig trading markets and to engage in massive naked short selling so that companies and their capital would be unknowingly at the mercy of a select few. It’s the new Rome, it’s called absolute power and I believe the bankers have acquired it or very nearly have. All that stands between them and their absolute power is the prospect of some governmental body looking at what they are doing.
One Quadrillion dollars is equivalent to a hundred years of output at current levels of the economy of the American civilization. There is likely a small risk of it imploding because of natural stability factors but the risk needs to be zero or so close to zero that implosion would be farfetched and all pathways to implosion would be monitored and nipped in the bud should they be seen to progress.
I say let America’s crazy uncle Ron Paul and his people get their nose into this. It would be no more damaging to unleash Paul than it would be in appointing a whiskey drinking drunk as commander of the armed forces (Ulysses S. Grant). My only concern would be if Paul and his people could be bought.
“...But the truth is that derivatives were at the heart of the financial crisis of 2007 and 2008,...”
derivatives, made possible by the left inspired and executed , never to be sufficiently cursed community reinvestment act (CRA...ptooey!).
Bank of America should be called Bank of Italy because that was who they were originally.
“If that is accurate, that means that the worldwide derivatives market is 20 times larger than the GDP of the entire world.
It is hard to even conceive of $1,000,000,000,000,000.”
Not really. It’s value is $1,000,000,000,000,000. - $1,000,000,000,000,000. = $0.
The problem comes when derivatives are counted as equity.
Just require that they have enough cash to cover their potential loses. That would be the end of derivatives.
Exactly. Rather than minimizing variation through the “Gaussian copula formula”, derivatives merely transfer the risk that isn’t properly calculated to another party. It amplifies risk. Time between market failures becomes much more indeterminate and the cause is hard to find.
The crunch come in bankruptcy court. The lawyers who before bankruptcy, were so sure their contracts were properly written find that even they can’t figure them out. They then look to the government for resolution to shortcut the legal battles.