For example: 2 parties may engage in a Swap transaction on a $100million notional amount. Bank "A" pays a fixed interest rate to Bank "B" and Bank "B, pays a floating rate (usually the LIBOR rate) to Bank "A". They are not exchanging the entire $100million. They are only exchanging interest payments on that $100 million on a monthly, quarterly, semi-annual or annual basis (whatever they agree to), so the true exposure is nowhere near the $100 million notional amount of the swap. If a bank on one side of the transaction goes under, the other side hasn't lost $100million, or anywhere close to it.
There are also regular bilateral netting and portfolio compression cycles that take place. These are processes by which offsetting trades are effectively "torn up" thereby removing them from the balance sheet of the banks involved in the transactions. Too much to elaborate upon here, but these compression cycles occur regularly and every big bank with derivatives exposure participates. Think of these cycles as maintenance, in which the deadwood and underbrush are removed in order to prevent a potential forest fire from spreading. We just had one of these compression cycles this past Friday in which $8.26 trillion of notional was terminated.
I am no Pollyanna, and I am gravely concerned about the stability of our financial sector, but derivatives have become the 'boogeymen' of world of banking and finance. So few people have any real clue as to how the derivatives market works so it is easy to lull people into the idea that derivatives are these complex and dangerous products with articles such as this one. Most people are not even aware of the various types of derivatives and what the actual risk is. We just see these huge numbers thrown around, hear the term 'derivative' and start calling for intervention to 'ban' these nefarious financial instruments. I only ask that people obtain a basic understanding of derivatives so that they are in a better position to evaluate the true impact of the claims being made in articles such as these.
Thank you for writing. You give more clarity than my post. I would ask you this. Recently, just last week, it was reported that Bank of America transferred 44 trillion in notional derivitives off of its books....I think to Morgan...but I am not sure of that.....but they did transfer 44 trillion. If the counterparties make demand on those 44 trillion of notional value, what would that translate in terms of actual liability to the counterparties. If it is only 1%, that is an astronomical number. Can you illucidate?
Thank you for writing. You give more clarity than my post. I would ask you this. Recently, just last week, it was reported that Bank of America transferred 44 trillion in notional derivitives off of its books....I think to Morgan...but I am not sure of that.....but they did transfer 44 trillion. If the counterparties make demand on those 44 trillion of notional value, what would that translate in terms of actual liability to the counterparties. If it is only 1%, that is an astronomical number. Can you illucidate?