Why derivatives are getting much more dangerous

By Associate Editor David Stevenson May 23, 2008

David Stevenson

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Sometimes when you’re scouring the news, you see a statistic that renders you almost speechless. You can't quite get your head around what it really means, you just know that it’s a knockout number.

One such figure came up yesterday. The total ‘value' of global derivatives - financial instruments which are priced on the back of the underlying assets that they track - has now reached a breathtaking $596 trillion, after a mammoth rise over the previous twelve months.

That started the warning lights flashing…

So what, apart from containing more noughts than a normal human being can cope with, is this titanic number all about?

Let’s start by putting it into context.  We can do this by checking out what the world actually made last year. The overall value of goods and services produced is measured by Gross Domestic Product (GDP). And for 2007, GDP for planet earth was reckoned by the International Monetary Fund to be just shy of $65 trillion. No less an organization than the CIA has come up with a similar estimate, at £65.8 trillion, so it must be about right.

So when the Bank for International Settlements (BIS) tells us that last year the total derivatives market grew by 44%, its fastest pace since the Basel-based bank started keeping records just over ten years ago, up go the antennae straightaway. And when that figure of $596 trillion crosses the radar screen, equivalent to more than nine times world GDP, the numbers are looking quite scary.

The money at risk is equivalent to a quarter of world output

Of course, the $596 trillion is a ‘notional’ amount. It’s the nominal value of all the underlying assets against which bets have been placed. But the actual amount of ‘real’ money at risk is still a massive $15 trillion, equal to almost a quarter of world output.

And within the individual areas there’s one even more eye-catching statistic. The value of contracts in credit default swaps (CDS) - a form of market insurance that investors can buy to protect themselves against corporate bond defaults - more than quadrupled last year to $2 trillion, covering a notional $58 trillion of loan debt.

The very size of all these numbers is just about enough to give the jitters to anyone, on the basis that when things can go wrong, they probably will.

When I wrote on this subject before, one respondent claimed that the topline numbers aren’t important because derivative markets are beautifully balanced. His theory was that if every derivatives position were hedging a risk relating to a specific transaction or asset, then derivatives would actually stabilise the world economy. All those noughts would be good news.

Sounds a bit too good to be true. And there are three reasons to be sceptical about this optimistic line of thinking.

Three reasons to be worried

Firstly, what we can call knowledge risk. That’s when derivatives players don’t know what they’re getting into.

A story on Bloomberg at the end of April summed this up pretty well. The chief finance officer of an Indian company was persuaded by his bank to start dabbling in the currency derivatives market. Although the CFO explained to the bankers that he didn’t understand how these products work, apparently they chauffeured him round and bombarded him with charts showing how his company could make a profit with a zero investment.

Too good to be true? Clearly it was. Three months later, two of the contracts had turned sour, incurring losses of $1.5 million and prompting the bank to issue a bankruptcy notice to recover the cash. Meanwhile, our poor CFO had no idea that these derivative bets could go so wrong. But he’s not alone. Indian companies could lose up to $4bn on derivatives, according to Hong Kong-based brokerage CLSA Ltd. Naïvety? Maybe. But we’re all good at repenting at leisure.
 
Which brings us onto the next potential problem, counterparty risk. That’s when the deal you’ve just done comes unstuck because the people on the other side of the trade can’t settle their side of the deal. A bit like backing the Derby winner, then finding the bookie can't pay up because he's run out of money.

Indian banks may lose up to $400m if they can't enforce derivatives contracts they’ve set up with smaller companies, says CLSA.  This is because 10% of these smaller companies may renege on their agreements because they haven’t the cash to settle the deals.
 
And this is just one country. BNP Paribas analyst Andera Cicione believes that total world CDS losses could hit $150bn. As the CDS market is unregulated, there are no public records showing whether sellers have the assets to pay out if a bond defaults. George Soros himself has warned this week that CDS counterparty risk is “a Damoclean sword waiting to fall.”

What’s worse – and here we come to the third problem - some buyers have now found out that the derivatives they’ve bought haven’t matched up to “what it said on the tin”.
 
The ratings agency Moody's has just admitted awarding incorrect ratings to $4bn worth of debt instruments because of a bug in its computer models. Some ultra-complex derivative products, known as “constant proportion debt obligations” and thought up at the height of the credit bubble, incorrectly received over-optimistic triple A – i.e. top notch - ratings. And it took Moody's nearly a year to find the problem.

As the derivatives market gets bigger and bigger, stories like these only make us ask: do the people who play around in it really know what they’re doing?

Turning to the wider markets:

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London shares ended the day lower, with the FTSE 100 index closing 16.5 points down at 6182. A strong performance from Vodafone helped limit losses, as the telecoms group added 3% after a favourable regulatory ruling in Italy on termination rates, the charges that phone operators impose on each other. Traders expect next week’s annual results to be good. After their recent trailblazing run, oil stocks slid back, with BG down 3.4% and Royal Dutch Shell off nearly 2%. Takeover talk boosted Cadbury by almost 2.5% but recent right issue candidate Imperial Tobacco slipped 4%.

In Europe in contrast, energy stock did well, with the top performer being Austrian oil and gas group OMV, while the Norwegian StatoilHydro gushed up 3.8% after this week’s gas discovery. In Germany the Xetra Dax gained 0.4% but in Paris, the French CAC index was virtually unchanged.

Wall Street nudged up slightly after the previous two days of heavy losses, with the Dow Jones Industrial Average adding 25 points to close 0.2% better 12626. Better than expected jobless data helped steady the ship, though some commodity price falls nit resource stocks. The broader S&P 500 also rose 0.2% while the tech-heavy Nasdaq flipped up 0.7%.

Overnight the Japanese market followed the States, with the Nikkei 225 advancing 0.2% to close at 14012, though in Hong Kong, the Hang Seng declined 1.3% to 24714.

Brent spot slid back, trading this morning at $130.6, while spot gold fell back to $923. Silver was trading at $18.10 and Platinum was at $2175.

Turning to forex, this morning sterling was again slightly firmer at 1.9785 against the US dollar, and also better against the euro at 1.2581. The dollar was last trading at 0.6357 against the euro and 103.79 against the Japanese yen.

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