“Three of the world’s most powerful financial regulators have taken the unusual step of issuing a joint warning that individual nations cannot contain some of the risks posed by the explosive growth of derivatives and must collaborate across borders.”
– Financial Times - Derivatives regulation must be ‘borderless’, September 29, 2006

How big is the derivative market? It is bigger than Stephen Roach thinks it is. Much bigger. But first Stephen:

“The excesses of the global liquidity cycle explain much of the new cushioning role world financial markets have played in warding off major shocks during the past several years…. The explosive growth of non-traditional sources of liquidity — especially derivatives — seriously complicates the measurement problem. BIS data put the notional value of global over-the-counter derivatives markets at US$285 trillion in December 2005 — up more than 40% from volumes just two years earlier and more than six times the nominal level of world GDP. The notion of being awash in liquidity takes on a very different meaning in this context.”
– Stephen Roach, Global: Global Resilience: At What Cost? - Oct 09, 2006

“Being awash in liquidity” caused by non-traditional sources of liquidity. What is the Dow Jones Index measuring these days? Does it take sips from the non traditional liquidity stream?

And the derivative market is much bigger than US$285 trillion. So which bank would be a good partner in todays global business environment? When we read that ABN-Amro toots its new structured invention, the CPDO [1], it does make us feel uncomfortable. We are familiar what happens when banks blow up. It ain’t a pretty sight.

Lets continue. I quote Roubini:

“Today you have trade protectionism and asset protectionism; hedgy and trigger-happy investors and rising geopolitical risks; the risk of a disorderly fall in the US dollar; a slush of financial derivatives that are a black box that no one truly understands (the operational risk in credit derivatives is only the tip of much larger systemic risk iceberg in these instruments, as the pricing of these instruments has not been tested in a real cycle of increasing corporate bankruptcies); increasing VARs and growing levels of leverage; frothy markets where years of too easy money have created bubbles galore - the latest in housing - that are ready to burst; a bubble of thousands of new hedge funds with inexperienced managers that have no supervision or regulation of their activities; risk management techniques in financial institutions that miserably fail to truly stress test for fat tail events; hedging strategies that — like in 1987 — can hedge nothing once everyone is rushing to the doors and dumping assets at the same time; and a housing markets whose rout may trigger systemic effects through the mortgage backed securities market and the non-transparent hedging activities of the GSEs.”
– Roubini, The Current Risks of a 1987-Style Financial Meltdown: The Scary Similarities between 2006 and 1987, Aug 12, 2006 [2]

Maybe we could state that the global stress test began with the popping housing bubble (asset prices).

Within the stress test setup, Its the black box called derivatives which is interesting. It is a cynical market where you are able to reap great rewards, like by betting that the global asset bubble shall burst, while spreading the risk throughout the system. They don’t like to take personal responsibility (privatizing profit, socializing risk). All under the guise of ‘respectable’ financial institutions.

Those who have been following this blog and the posts for some time have a certain grasp of how huge the global derivative market is. How it has spread into every nook and cranny of the global financial economy within a measly ten years. This market, starting in the 70ties [3], really started to fire up its engines in 1996 and had a turbo charge on top of it at the start of 2001.

The derivative market is big. Very big. It has become a quadrillion market. The trillion is left in the dust. The billion is small change. And the million is an arcane word. …A dollar? One dollar? Probably only useful in the real economy (real life). To buy food with.

One quadrillion is 1,000 trillion. We are talking about US dollars.

Do not worry if you are baffled by the huge number quadrillion. Truly, it is of historic proportions and best digested with a glass of wine or your favorite scotch in hand. So lets fire off with another warning and wonder whom is aware of how big the derivative market is. “Jean-Claude Trichet, president of the European Central Bank, hinted strongly last night that he would prefer tougher regulation of hedge funds but said any measures would have to represent “a global solution”. [4]

Why is it, that I always hope for a typo. I want to read a ‘dot’ instead of a ‘comma’. If find 1.6 trillion more realistic than 1,600 trillion, which is 1.6 quadrillion.

So here we go.

Christian Upper wrote a report called Derivatives activity and monetary policy [5] and there we read:

“Short-term interest rate risk can also be traded over the counter (OTC) using a variety of instruments such as forward rate agreements, swaps, caps, floors and collars. Unfortunately, data on activity in OTC contracts are available only at relatively low frequencies and with a very coarse instrument breakdown. As a consequence, the analysis that follows is limited to exchange-traded futures and options, with only passing references to the OTC market.”

Christian Uppers analysis is limited to exchange-traded futures and options. We will grab the OCT numbers as well:

“The latest BIS statistics on trading in exchange-traded derivatives markets, for the second quarter of 2006, indicate that the combined turnover of interest rate, equity index and currency contracts increased by 13% from the first quarter. The turnover of contracts on short-term yen interest rates soared several months ahead of the rate hike by the Bank of Japan. There was also heavy trading of equity index contracts in May and June, during the retreat from risky assets.” [6].

First quarter 2006 [7] was $429 trillion. Increased by 13% is $484.77 trillion. Lets round it up to $485 trillion dollars for the second quarter of 2006. Plus the numbers that Christian Upper reports over 2006 [8]. Which is a total of $1,600 trillion (and this number will grow for 2006, we haven’t closed this year yet).

Well. What do you know… That is 1,600 + 485 = $2,085 trillion dollars. That is over $2 quadrillion dollars. Or 48 times the gross domestic product of what the human species produces every year on this planet (which is ‘real’ $43 trillion and ‘adjusted’ $61 trillion [9].)

Quadrillion here, quadrillion there, the biggest gambling and debt bubble in history. My estimation is that the global derivative market (financial derivatives and normal ones, over cotton, oil and potatoes etc.), stands around $2.3 quadrillion for the midst of 2006…

Still, these number read more like an urban legend than the real deal. They are so preposterous. Should we take these numbers seriously in the first place? Just like the tulip bubble. Which didn’t effect the real economy very much.

“Tulip mania differed in one crucial aspect from the dot-com craze that grips our attention today: Even at its height, the Amsterdam Stock Exchange, well-established in 1630, wouldn’t touch tulips. ”The speculation in tulip bulbs always existed at the margins of Dutch economic life,” Dash writes. After the market crashed, a compromise was brokered that let most traders settle their debts for a fraction of their liability. The overall fallout on the Dutch economy was negligible. Will we say the same when Wall Street’s current obsession finally runs its course?”
– Mike Dash, When the Tulip Bubble Burst, April 24, 2000 [10]

The difference is that in those days the real investor took reality seriously, in ‘modern times’, it seems to be computer models. When the computer is switched on, common sense is switched off.

J.

***

A trip with Alice in Model Land

__We start with presumptions, ending with China__

Ceteris paribus remains important within many computing models…

Ceteris paribus may well be the two most dangerous words in the economist’s toolkit. Loosely translated from Latin as “all other things being the same,” this concept has become a foil for partial-equilibrium analysis — an increasingly fruitless and misleading approach in today’s complex and interdependent world. With oil prices rising, the housing cycle turning, and central banks tightening, the pitfalls of ceteris paribus have never been greater.
– Stephen S. Roach, The Pitfalls of Ceteris Paribus, Jul 28, 2006

What kind of models? Like these:

“The present situation “is not dissimilar” to the one that preceded the collapse of LTCM, says Michael Thompson, a strategist at RiskMetrics, a consultancy that specialises in the very risk-management models that banks use. Like LTCM, banks are building up huge positions in the expectation that markets will remain stable. They are, says Mr Thompson, “walking themselves to the edge of the cliff”. This is because—as all past financial crises have shown—the risk-management models they use woefully underestimate the savage effects of big shocks, when everybody is trying to wriggle out of their positions at the same time…”
– Buttonwood, Banks… really learned nothing?, February 17, 2004

Insert the debt variable…

“…the lending is increasingly being orchestrated from outside the regulated banking industry, by hedge funds and other credit investors that are often supervised only indirectly, if at all. These are especially big in the booming market for credit derivatives, which are also traded outside public exchanges.”

Business is being reshaped by a massive borrowing binge, but much of it is unseen, unregulated and little understood”
– In the shadows of debt, The Economist, Sep 21st 2006

Lets ’structure and model’ a vagueness called ‘risk’…

“The word “derivative” is itself a derivative — it is used to describe a contract that is referenced to, or “derived from,” underlying cash or physical financial markets. Markets for such items as foreign exchange, or debt and equity securities, or even the general bond and stock markets in which they trade are all good examples.

Now, a derivative is a contract, or even a bundle of contractually created rights and obligations, based on future price expectations for specific financial markets. Each contract has a buyer and seller and a middleman or counterparty that has arranged the contract. Inevitably, each time we hear of the use of financial derivatives we almost always also hear the words “risk management.”

That is to say, those who play with these often-dicey financial bomblets generally excuse their use by explaining it away as a means of modifying risk. For example, a gold mining company can employ derivatives as a hedge against price movements beyond certain limits. That company might sell calls to deliver gold above a certain price and use the funds received to acquire gold at a lower price. Voila´! The company has transferred the risk of gold price movements off its balance sheet and underlying income statement — it has “risk-managed” the impact of price volatility out of its business model.”
– Prescott Crocker, Derivative hedge funds are ticking like time bombs, March 22, 2002

Do the Chinese know the risk they take?

“Chinese commercial banks, in joining the game of international competition under WTO rules, will be forced to participate in the credit derivatives markets, which are time bombs of massive systemic financial destruction.”
– Henry C K Liu, PART 3: China’s internal debt problem, May 27, 2006

***

Notes

[1]

“ABN Amro Holding NV is credited with inventing the CPDO structure. A 38-page marketing brochure dated June 2006 describes a security called “Surf — the First CPDO; a Breakthrough in Credit Investments.” The concept, though, has been around for longer; a July 2004 research note from Societe Generale SA describes a “Dynamic Portfolio Insurance” strategy that has the same characteristics as a CPDO.”
– Mark Gilbert, CPDOs Are Derivatives Market’s New Alchemy Trick, November 14, 2006

[2] http://www.rgemonitor.com/blog/roubini/140982

[3] To be more specific. Current day Financial derivatives combined with computing power started ‘officialy’ in Chicago 1971. Betting on interest, bond quality, currencies etc. It is unregulated in the US. And has some (but useless because it doesn’t work) regulation world wide. The financial derivatives would become a market which would contaminate the ‘old fashioned’ derivatives over potatoes, oil, copper (soft and hard raw materials) etc. The global financial derivative market is a market of perception, fueled by the repo market, which in turn took off with the carry trade circus. Tied together with risk models nicely run on computing power.

[4]

Ralph Atkins, ECB president stresses risk of hedge funds, October 10 2006

[5]

Derivatives activity and monetary policy, September 2006, BIS. (The views expressed in this article are those of the author and do not necessarily reflect those of the BIS.)

http://www.bis.org/publ/qtrpdf/r_qt0609h.htm http://www.bis.org/publ/qtrpdf/r_qt0609h.pdf (pdf)

[6] http://www.bis.org/press/p060911.htm

[7] http://www.bis.org/press/p060612.htm

[8]

Page 3 of the pdf version (http://www.bis.org/publ/qtrpdf/r_qt0609h.pdf). Page 67 of the report itself.

Christian has this, in my opinion, strange conclusion. Here a small part of it:

“In a world with more transparent central banks and monetary policy…” (page 75)

Transparant? The head of the FED Bernanke wants to be more open, while closing upon reports (the M3. The ECB finds the M3 important). Ah… More repo worries…

[9] https://www.cia.gov/cia/publications/factbook/geos/xx.html#Econ

[10] http://bazaarmodel.net/phorum/read.php?1,2222

***

“Today’s investors face a difficult choice, one they’re not to be envied for. They can see the relative weakness of the US economy and they’re registering the tectonic shifts in the world economy. They know that a great statistical effort is being made to prolong the American dream. For some time now, government statistics have announced sensational productivity leaps for the US economy — productivity leaps that, strange as it may seem, haven’t led to any rise in wages for years. This is in fact genuinely bizarre: Either capitalists are reaping the fruits of increased productivity all by themselves — which would be a political scandal even in capitalism’s heartland — or the productivity leaps exist only on paper. There is much to suggest that the second hypothesis is correct.

Half the world is impressed by the low levels of unemployment in the United States. The other half knows that these statistics aren’t official, but the result of a voluntary telephone survey. Many of those who declare themselves employed are assistants and day workers. Working just one hour a week is enough for one to be classified as “employed.” Given that it’s considered antisocial to declare yourself unemployed, the US statistics may well say more about American society’s dominant norms than about its actual condition.

The US economy’s high growth rates aren’t to be completely trusted either. They are the result of high public and private debt. In no way do they express an increased output of domestically produced goods and services that the United States has achieved by its own strength. They say more about the successful sales ventures of Asians and Europeans. New loans taken by the US government were responsible for fully one-third of US economic growth in 2001. In 2003 they were responsible for a quarter. The United States is an economic giant on steroids — doped so its decline in performance doesn’t become too apparent.”

– Gabor Steingart, America and the Dollar Illusion, October 25, 2006

(This writing was first posted at Roubini)