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Big Risk: $1.2 Quadrillion Derivatives Market Dwarfs World GDP (Anyone understand the risk?)
Daily Finance ^ | 06/09/2010 | Peter Cohan

Posted on 06/09/2010 12:36:11 PM PDT by SeekAndFind

One of the biggest risks to the world's financial health is the $1.2 quadrillion derivatives market. It's complex, it's unregulated, and it ought to be of concern to world leaders that its notional value is 20 times the size of the world economy. But traders rule the roost -- and as much as risk managers and regulators might want to limit that risk, they lack the power or knowledge to do so.

A quadrillion is a big number: 1,000 times a trillion. Yet according to one of the world's leading derivatives experts, Paul Wilmott, who holds a doctorate in applied mathematics from Oxford University (and whose speaking voice sounds eerily like John Lennon's), $1.2 quadrillion is the so-called notional value of the worldwide derivatives market. To put that in perspective, the world's annual gross domestic product is between $50 trillion and $60 trillion.

To understand the concept of "notional value," it's useful to have an example. Let's say you borrow $1 million to buy an apartment and the interest rate on that loan gets reset every six months. Meanwhile, you turn around and rent that apartment out at a monthly fixed rate. If all your expenses including interest are less than the rent, you make money. But if the interest and expenses get bigger than the rent, you lose.

You might be able to hedge this risk of a spike in interest rates by swapping that variable rate of interest for a fixed one. To do that you'd need to find a counterparty who has an asset with a fixed rate of return who believed that interest rates were going to fall and was willing to swap his fixed rate for your variable one.

The actual cash amount of the interest rates swaps might be 1% of the $1 million debt, while that $1 million is the "notional" amount. Applying that same 1% to the $1.2 quadrillion derivatives market would leave a cash amount of the derivatives market of $12 trillion -- far smaller, but still 20% of the world economy.

Getting a Handle on Derivatives Risk

How big is the risk to the world economy from these derivatives? According to Wilmott, it's impossible to know unless you understand the details of the derivatives contracts. But since they're unregulated and likely to remain so, it is hard to gauge the risk.

But Wilmott gives an example of an over-the-counter "customized" derivative that could be very risky indeed, and could also put its practitioners in a position of what he called "moral hazard." Suppose Bank 1 (B1) and Bank 2 (B2) decide to hedge against the risk that Bank 3 (B3) and Bank 4 (B4) might fail to repay their debt to B1 and B2. To guard against that, B1 and B2 might hedge the risk through derivatives.

In so doing, B1 and B2 might buy a credit default swap (CDS) on B3 and B4 debt. The CDS would pay B1 and B2 if B3 and B4 failed to repay their loan. B1 and B2 might also bet on the decline in shares of B3 and B4 through a short sale.

At that point, any action that B1 and B2 might take to boost the odds that B3 and B4 might default would increase the value of their derivatives. That possibility might tempt B1 and B2 to take actions that would boost the odds of failure for B3 and B4. As I wrote back in September 2008 on DailyFinance's sister site, BloggingStocks, this kind of behavior -- in which hedge funds pulled their money out of banks whose stock they were shorting -- may have contributed to the failures of Bear Stearns and Lehman Brothers.

It's also the sort of conduct that makes it extremely difficult to estimate the risk of the derivatives market.

How Positive Feedback Loops Crash Markets

Another kind of market conduct that makes markets volatile is what Wilmott calls positive and negative feedback loops. These relatively bland-sounding terms mask some really scary behavior for investors who are not clued into it. Wilmott argues that a positive feedback loop contributed to the 22.6% crash in the Dow back in October 1987.

In the 1980s, a firm run by some former academics came up with the idea of portfolio insurance.

Their idea was that if investors are worried about their assets losing value, they can buy puts -- the option to sell their investments at pre-determined prices. They can sell everything -- which would be embarrassing if the market then started to rise -- or they could sell a fixed proportion of their portfolio depending on the percentage decline in a particular stock market index.

This latter idea is portfolio insurance. If the Dow, for example, fell 3%; it might suggest that investors should sell 20% of their portfolio. And if the Dow fell 20%, it would indicate that investors should sell 100% of their portfolio.

That positive feedback loop -- in which a stock price decline leads to more selling -- boosts market volatility. Portfolio insurance causes more investors to sell as the market declines by, say 3%, which causes an even deeper plunge in the value of investors' holdings. And that deeper decline leads to more selling. Before you know it, many investors are selling everything.

The portfolio insurance firm started off with $5 billion, but as its reputation spread, it ended up managing $50 billion. In 1987, that was a lot of money. So when that positive feedback loop got going, it took the Dow down 22.6% in a day.

The big problem back then was the absence of a sufficient number of traders using a negative feedback loop strategy. With a negative feedback loop, a trader would sell stocks as they rose and buy them as they declined. With a negative feedback loop strategy, volatility would be far lower.

Unfortunately, data on how much money has been going into negative and positive feedback loop strategies is not available. Therefore, it's hard to know how the positive feedback loops have gained such a hold on the market.

But it is not hard to imagine that if a particular investor made huge amounts of money following a positive feedback loop strategy, other investors would hear about it and copy it. Moreover, the way traders get compensated suggests that it's better for them to take more and more risk to replicate what their peers are doing.

Traders Make More Money By Following the Pack

There is a clear economic incentive for traders to follow what their peers are doing. According to Wilmott, to understand why, it helps to imagine a simplified example of a trading floor. Picture yourself as a new college graduate joining a bank's trading floor with 100 traders. Those 100 traders each trade $10 million: They "win" if a coin toss lands on heads and "lose" if it lands on tails. But now imagine you've come up with a magic coin that has a 75% chance of landing on heads -- you can make a better bet than the other 100 traders with their 50-50 coin.

You might think that the best strategy for you would be to bet your $10 million on that magic coin. But you'd be wrong. According to Wilmott, if the magic coin lands on a head but the other 100 traders flip tails, the bank loses $1 billion while you get a relatively paltry $10 million.

The best possible outcome for you is a 37.5% chance that everyone makes money (the 75% chance of you tossing heads multiplied by the 50% chance of the other traders getting a head). If instead, you use the same coin as everyone else on the floor, the probability of everyone getting a bonus rises to 50%.

When Traders Say 'Jump,' Risk Managers Ask 'How High?'

Traders are a huge source of profit on Wall Street these days and they have an incentive to bet together and to bet big. According to Wilmott, traders get a bonus based on the one-year profits of those on their trading floor. If the trading floor makes big money, all the traders get a big bonus. And if it loses money, they get no bonus -- but at least they don't have to repay their capital providers for the losses.

Given that bonus structure, a trader is always better off risking $1 billion than $1 million. So if the trader, who is the king of the hill at the bank, asks a lowly risk manager to analyze how much risk the trader is taking, that risk manager is on the spot. If the risk manager comes back with a risk level that limits how big a bet the trader can take, the trader will demand that the risk manager recalculate the risk level lower so the trader can take the bigger bet.

Traders also manipulate their bonuses by assuming the existence of trading profits before they are actually realized. This happens when traders get involved with derivatives that will not unwind for 20 years.

Although the profits or losses on that trade have not been realized at the end of the first year, the bank will make an assumption about whether that trade made or lost money each year. Given the power traders wield, they can make the number come out positive so they can receive a hefty bonus -- even though it is too early to tell what the real outcome of the trade will be.

How Trader Incentives Caused the CDO Bubble

Wilmott imagines that this greater incentive to follow the pack is what happened when many traders were piling into collateralized debt obligations. In Wilmott's view, CDO risk managers who had analyzed a future scenario in which housing prices fell and interest rates rose would have concluded that the CDOs would become worthless under that scenario. He imagines that when notified of that possible outcome, CDO traders would have demanded that the risk managers shred that nasty scenario so they could keep trading more CDOs.

Incidentally, the traders who profited by going against the CDO crowd were lone wolves whose compensation did not depend on following the trading floor pack. This reinforces the idea that big bank compensation policies drive dangerous behavior that boosts market volatility.

What You Don't Understand, You Can't Properly Regulate

Wilmott believes that derivatives represent a risk of unknown proportions. But unless there is a change to trader compensation policies -- one which would force traders to put their compensation at risk for the life of the derivative -- then this risk could remain difficult to manage.

Unfortunately, he thinks that regulators aren't in a good position to assess the risks of derivatives because they don't understand them. Wilmott offers training in risk management. While traders and risk managers at banks and hedge funds have taken his course, regulators so far have not.

And if regulators don't understand the risks in derivatives, chances are great that Congress does not understand them either.

TOPICS: Business/Economy; Culture/Society; News/Current Events
KEYWORDS: derivatives; quadrillion; risk
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Peter Cohan is a columnist for DailyFinance. He is president of Peter S. Cohan & Associates, a management consulting and venture capital firm. His ninth book, co-authored with Professor U. Srinivasa Rangan, is Capital Rising: How Global Capital Flows are Changing Business Systems All Over the World. The Achiever Newsletter ranked his eighth book, You Can't Order Change: Lessons from Jim McNerney's turnaround at Boeing, as the #1 business book of 2009. He teaches business strategy to undergraduate and MBA students at Babson College and has also taught at Stanford, MIT, Columbia, and the University of Hong Kong. He has appeared on ABC's "Good Morning America," CNBC, CNN, Fox Business News and the Boston ABC and CBS affiliates. He has been quoted in The New York Times, The Wall Street Journal, Bloomberg News, Time, Newsweek, Fortune, and Business Week.

1 posted on 06/09/2010 12:36:12 PM PDT by SeekAndFind
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To: SeekAndFind
I bet some cool-aide drinking republican will be along shortly and say barney the queer did it.
2 posted on 06/09/2010 12:39:12 PM PDT by org.whodat
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To: SeekAndFind

No one ‘understands’ the risks. It’s just some have the patter down better. The narrative, the story.

3 posted on 06/09/2010 12:40:46 PM PDT by Leisler ("Over time they create a legal system that plunders and a moral code that glorifies it." F. Bastiat)
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To: org.whodat

I bet some troll will be along shortly to imply that Republicans did it.

4 posted on 06/09/2010 12:41:02 PM PDT by ClearCase_guy
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To: SeekAndFind

“it’s unregulated”


5 posted on 06/09/2010 12:41:56 PM PDT by aMorePerfectUnion
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To: SeekAndFind

Don’t be telling the gangsta’s in this thugocracy about quadrillions. They’ll be wanting to spend it, and borrow some more.

6 posted on 06/09/2010 12:42:03 PM PDT by pallis
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To: SeekAndFind
Deregulate it all. Don't pretend that the government has any control over it, because it doesn't. Any time they put in rules, others put in strategies to benefit from or counter the rules, and we get back to the start, with more people demanding regulating the market.

End it. No bank account insurance, tell people ‘Hey, you wanna go toss your money around, sure, just don't come crying to us when it all gets scammed away from you.’

7 posted on 06/09/2010 12:44:12 PM PDT by kingu (Favorite Sticker: Lost hope, and Obama took my change.)
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To: SeekAndFind

So what happens if these derivatives blow up, and there are losses which exceed world GDP? Every transaction has a winner and a loser so let’s just say for the sake of a strawman argument with a scary bogeyman, that George Soros is the one guy who wins and is owed more than world GDP. How does he collect? Will governments commit suicide by enforcing the payments and destroying their own economies and industries or will they tell Soros to pound sand?

8 posted on 06/09/2010 12:45:24 PM PDT by pepsi_junkie (Who is John Galt?)
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To: SeekAndFind

Why scam trillions when you can scam... quadrillions?
9 posted on 06/09/2010 12:46:25 PM PDT by Jack Hydrazine (It's the end of the world as we know it and I feel fine!)
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To: pallis

I tried once to explain this concept of chaining of derivatives to the guy who cleans up our office ( a great black guy to talk to ), and tried to let him appreciate how difficult it is to determine how much one insitution owes another when the whole thing collapses.

His response to me was this : “Why not start all over and let nobody owe nobody nuthin’ ?”

10 posted on 06/09/2010 12:47:46 PM PDT by SeekAndFind
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To: Leisler
This is a scary story.

What I am even more scared about is that Obama might read it and find out what comes after a trillion.

11 posted on 06/09/2010 12:50:11 PM PDT by USNBandit (sarcasm engaged at all times)
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To: SeekAndFind; blam; FromLori
All-this-fluff-and-not-a-single-mention-of-how-this-is-only-possible-via-fiat-currency-and-central-banks ping.

Frowning takes 68 muscles.
Smiling takes 6.
Pulling this trigger takes 2.
I'm lazy.

12 posted on 06/09/2010 12:50:47 PM PDT by The Comedian (Evil can only succeed if good men don't point at it and laugh.)
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To: SeekAndFind
“Why not start all over and let nobody owe nobody nuthin’ ?”

Wise beyond his job description. That probably IS what will happen. Everyone will be bankrupt.

13 posted on 06/09/2010 12:52:37 PM PDT by 21twelve ( UNINTENDED CONSEQUENCES MY ARSE: " begin the work of remaking America."-Obama, 1/20/09)
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To: ClearCase_guy

My bet is on the Brain Dead Liberal Free Trade Globalist....who loves the UN, WTO, Communist China and George Soros more than he loves America....tells us “how great derivatives are”....especially when they are 20 X the worth of the entire wealth on the Globe

14 posted on 06/09/2010 12:52:53 PM PDT by UCFRoadWarrior (JD for Senate ..... You either voting for JD, or voting for the Liberal...)
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To: org.whodat

Interesting observation.

15 posted on 06/09/2010 12:58:34 PM PDT by Robert A Cook PE (I can only donate monthly, but socialists' ABBCNNBCBS continue to lie every day!)
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To: The Comedian

All-this-fluff-and-not-a-single-mention-of-how-this-is-only-possible-via-fiat-currency-and-central-banks ping.>>>>>>

The fiat currencies of all developed countries are highly leveraged at this point. This mountain of derivatives takes these currencies and builds on them, leveraging them even further.

Very few derivatives have anything to do with real wealth creation. Commodity futures contracts are very simple derivatives that at least have something to do with cotton or soybeans

16 posted on 06/09/2010 1:01:47 PM PDT by dennisw (History does not long entrust the care of freedom to the weak or the timid - Gen Eisenhower)
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To: SeekAndFind
His response to me was this : “Why not start all over and let nobody owe nobody nuthin’ ?”

A very Old Testament concept called Jubilee.

17 posted on 06/09/2010 1:03:38 PM PDT by Disambiguator (Progressivism, Socialism, Marxism, Communism - it's all shades of black.)
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To: SeekAndFind

What happens if you add in all the action on the Lakers’ game?

18 posted on 06/09/2010 1:03:41 PM PDT by Defiant (Obama hawking Special K--
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To: Disambiguator
A very Old Testament concept called Jubilee.

Tell me more. I think that is where it will end up, much as Romans probably lost both their property and their debts around 476 AD.

19 posted on 06/09/2010 1:05:12 PM PDT by Defiant (Obama hawking Special K--
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To: SeekAndFind


20 posted on 06/09/2010 1:05:46 PM PDT by griswold3 (Barack Obama’s First Law of Leadership: “I just work here.”)
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