The Bank for International Settlements (BIS) just published a statistical study on the amount of derivatives worldwide at the end of 2013, and they reach the astronomical amount of $710 Trillions ($710,000,000,000,000). For comparison purposes, the United States GDP in 2013 amounts to $16 Trillion, or 44 times less. And this mass of derivatives beats by 20% the preceding record, dating just before the 2008 crisis... We hear a lot about bubbles these days, in the stock market, the bond market or in the commodities market, but this one is without a doubt the greatest one.
What is a derivative? It’s a contract between two parties, which value is determined by variations in the price of an underlying asset (bond, stocks, commodities, currencies). It is used to either protect against price or interest rate fluctuations, or to speculate. Another type of derivative, the CDS (Credit Default Swap), is used for protection against a default event (from a borrower, a State or a business). The majority of those contracts are negotiated one on one, and not on a market, in other words, in total darkness.
Another reason to be worried : In the United States, the largest portion of those products is owned by only four banks (JP Morgan, CitiBank, Goldman Sachs and Bank of America). In Europe, there is also a high concentration with, notably, the Deutsche Bank (we wrote about it) and the french banks. There is an enormous volume, but trades are done among very few actors.
When we voice our fears about these amounts, the bankers explain that we have nothing to worry about since these bets are compensated for and, at the end, net exposure is close to zero. They explain that positions are balanced, because when a bank takes a position on a derivative, it also purchases the opposite position for hedging... but who does it buy it from? From another bank. Thus, all the big banks sell one another derivatives, which explains the monopolistic concentration discussed above, and which means that if one of them defaults, they all go under! That’s what almost happened with AIG’s bankruptcy in September 2008 : AIG was the counterparty to many banking institutions, and it had to be saved at the last minute by the american government.
The best known of those products are the CDSs, but they only make for a small part of the whole. The main part of those derivatives (82% exactly), according to the BIS, is made of interest rate derivatives, of a globally equivalent amount in the United States and Europe, and this is where it becomes interesting. Fundamentally, interest rates in the United States and in Europe do not result from free market interactions; they are being manipulated lower by the central banks (the Fed and the ECB) who are doing everything to maintain them at the lowest possible. Any change in their monetary policy is communicated way ahead of time, which gives everyone time to readjust their previsions. This way, they provide false insurance to the market operators, who then engage in more risky operations. If ever the central banks were to lose control, if some crises or crashes would prove too hard to reign in or would render these institutions untrustworthy, these interest rates could experience brisk moves that could surprise the markets. And the mountain of derivatives would explode. And the aftermath would be just as hard to imagine as it is hard to fathom the amount mentioned at the start of this article.
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Philippe Herlin Finance Researcher / Doctor in Economics
Philippe Herlin is a researcher in finance and a doctor in economics of the Conservatoire National des Arts et Métiers in Paris. A proponent of extreme-risk thinkers like Benoît Mandelbrot and Nassim Taleb, and of the Austrian School of Economics, he will be bringing his own views on the actual crisis, the Eurozone, the public debts and the banking system. Having written a book on gold that has become a reference (L’or, un placement d’avenir, Eyrolles 2012), he wishes to see gold play a growing role in our economies, all the way to its full re-monetization.