$700 trillion derivatives market

The derivatives market is worth $700 TRILLION! MarketWatch’s Thomas Kostigen puts that incredible number in perspective:

[Residential real estate] at best worth $23 trillion in the U.S. We’re struggling to save the stock market, but that’s valued at less than $15 trillion. And we hope to keep the entire U.S. economy from collapsing, yet gross domestic product stands at $14.2 trillion… The total value of all the stock markets in the world amounts to less than $50 trillion.

Besides gigantic, the derivatives market is also opaque. When you buy an option on a regular exchange, you don’t have to worry about “counterparty risk” because you’re required to maintain an adequate margin account as the value of your option rises and falls. If you fail to make a margin call, the exchange immediately closes out your position. Everyone trades with the exchange, not another trader, and the exchange ensures that derivatives traders pay their losses and receive their gains.

This is not so with derivatives traded bilaterally. When you write a derivative contract with another party, you expose yourself to “counterparty risk.” The other party may not pay on time. They might go bankrupt. They might sell their derivative contract to a third party, which might in turn sell it to another party, which might go bankrupt. That’s tremendously dangerous to you.

But it’s even more dangerous to the system as a whole because no one knows who holds what contracts with whom. So no one knows which institutions are financially solid and which are zombies. Once the economy turns down, institutions become unwilling to lend to or trade with one another for fear their counterparty will go bankrupt. Creating an opaque $700 trillion web of derivatives is truly insane and should have been totally illegal. But that’s exactly what we have today. Consequently, it’s hard to see a happy ending to our current nightmare:

Few know what derivatives are worth. I spoke with one derivatives trader who manages billions of dollars and she said she couldn’t even value her portfolio because “no one knows anymore who is on the other side of the trade.”

…That’s why stabilizing the housing market will do little to take the sting out of the snapback we are going through on Wall Street… It isn’t the housing market devaluation, or the sub-prime mortgage market defaults that have us in real trouble. Those are nice fakes to sway attention away from the place where greed truly flourished — trading phony instruments to the tune of $700 trillion.

Posted by James on Tuesday, March 10, 2009