There seems a disconnect between the value of the underlying assets and the leveraged creation of money by the bets.
I have read the value of the world derivatives market is somewhere around a quadrillion dollars. Which if true is many times greater than the real world economy. This market would represent creation of substantial amounts of "funny" money basically created out of thin air over the last 10 years or so.
Of course, I am not an economist but that is my laymens understanding.
A credit default swap (CDS) is a credit derivative contract between two counterparties. The buyer makes periodic payments (premium leg) to the seller, and in return receives a payoff (protection or default leg) if an underlying financial instrument defaults.[1] CDS contracts have been incorrectly compared with insurance, because the buyer pays a premium and, in return, receives a sum of money if a specified event occurs. However, there are a number of differences between CDS and insurance; the buyer of a CDS does not need to own the underlying security; in fact the buyer does not even have to suffer a loss from the default event.
As an example, imagine that an investor buys a CDS from ABC Bank, where the reference entity is XYZ Corp. The investor will make regular payments to ABC Bank, and if XYZ Corp defaults on its debt (i.e., misses a coupon payment or does not repay it), the investor will receive a one-off payment from ABC Bank and the CDS contract is terminated. If the investor actually owns XYZ Corp debt, the CDS can be thought of as hedging. But investors can also buy CDS contracts referencing XYZ Corp debt, without actually owning any XYZ Corp debt. This may be done for speculative purposes, to bet against the solvency of XYZ Corp in a gamble to make money if it fails, or to hedge investments in other companies whose fortunes are expected to be similar to those of XYZ.
Credit default swaps are by far the most widely traded credit derivative product.[10] The Bank for International Settlements reported the notional amount on outstanding credit default swaps to be $42.6 trillion[11] in June 2007, up from $28.9 trillion in December 2006 ($13.9 trillion in December 2005). By the end of 2007 there were an estimated $45 trillion[12] to $62.2 trillion[13] worth of credit default swap contracts outstanding worldwide. ... There is no centralised exchange or clearing house for CDS transactions; they are all done over the counter (OTC).
They create contingent liabilities, but not money. Most economists teach a theoretical framework that has been shown to be fundamentally useless. -- James K. Galbraith
They create contingent liabilities, but not money.
Yes, they are highly leveraged, contingent liabilities. If the liabilities are due, the money needed is real money coming from the real economy. If large numbers of liabilities come due at the same time as with the mortgage bust, then the amounts due can be enormous.
Here is the website with the quadrillion dollar quote. Not sure how much to trust the numbers...
http://www.siliconvalleywatcher.com/mt/archives/2008/10/the_size_of_der.php
The Invisible One Quadrillion Dollar Equation -- Asymmetric Leverage and Systemic Risk According to various distinguished sources including the Bank for International Settlements (BIS) in Basel, Switzerland -- the central bankers' bank -- the amount of outstanding derivatives worldwide as of December 2007 crossed USD 1.144 Quadrillion, ie, USD 1,144 Trillion. The main categories of the USD 1.144 Quadrillion derivatives market were the following:
b. Credit Default Swaps at about USD 58+ trillion;
c. Foreign Exchange Derivatives at about USD 56+ trillion;
d. Commodity Derivatives at about USD 9 trillion;
e. Equity Linked Derivatives at about USD 8.5 trillion; and
f. Unallocated Derivatives at about USD 71+ trillion.
Quadrillion? That is a number only super computing engineers and astronomers used to use, not economists and bankers! For example, the North star is "just" a couple of quadrillion miles away, ie, a few thousand trillion miles. The new "Roadrunner" supercomputer built by IBM for the US Department of Energy's Los Alamos National Laboratory has achieved a peak performance of 1.026 Peta Flop per second -- becoming the first supercomputer ever to reach this milestone. One Quadrillion Floating Point Operations (Flops) per second is 1 Peta Flop/s, ie, 1,000 Trillion Flops per second. It is estimated that all the data found on all the websites and stored on computers across the world totals more than One Exa byte of memory, ie, 1,000 Quadrillion bytes of data.
Whilst outstanding derivatives are notional amounts until they are crystallised, actual exposure is measured by the net credit equivalent. This is normally a lower figure unless many variables plot a locus in the wrong direction simultaneously. This could be because of catastrophic unpredictable events, ie, "Black Swans", such as cascades of bankruptcies and nationalisations, when the net exposure can balloon and become considerably larger or indeed because some extremely dislocating geo-political or geo-physical events take place simultaneously. Also, the notional value becomes real value when either counterparty to the OTC derivative goes bankrupt. This means that no large OTC derivative house can be allowed to go broke without falling into the arms of another. Whatever funds within reason are required to rescue failing international investment banks, deposit banks and financial entities ought to be provided on a case by case basis. This is the asymmetric nature of derivatives and here lies the potential for systemic risk to the global economic system and financial markets if nothing is done.
Let us think about the invisible USD 1.144 quadrillion equation with black swan variables -- ie, 1,144 trillion dollars in terms of outstanding derivatives, global Gross Domestic Product (GDP), real estate, world stock and bond markets coupled with unknown unknowns or "Black Swans". What would be the relative positioning of USD 1.144 quadrillion for outstanding derivatives, ie, what is their scale:
I note that the other regular use of peta I've seen is, strangely enough, that natural gas is priced in Australia in dollars per petajoule. In the long run, we're all dead. John Maynard Keynes
The notional amounts outstanding on derivatives traded on exchanges was $28 tn in March 2008, while the quarterly turnover was $487 tn (we'd need someone who knows the functioning of the futures markets to explain that fully).
So I don't know.
That is actually in the ballpark for the numbers listed in the SiliconValley article. If the credit derivatives number is correct, then the quadrillion dollar plus sounds about right.
Exactly. Thanks for the correct terminology. In the event of some contingencies, that could require more "real money" than is available. Probably why Buffet referred to them as "financial weapons of mass destruction." As the Dutch said while fighting the Spanish: "It is not necessary to have hope in order to persevere."
that money isn't funny, it's terrifying.
Might be funny to play a little with the axes and some log-scales, though.
- Jake If you only spend 20 minutes of the rest of your life on economics, go spend them here.
If we bet one Euro on a coin toss, no money is created. We simply toss a coin and transfer an existing Euro between us in the appropriate direction.
If I am a bank and I loan you a Euro, 97 cents of that Euro are newly created money that didn't exist before. As you repay the loan, that loan-created money ceases to exist.
That the notional value of all derivatives is so huge just means that people have entered into too many bets. But that doesn't mean that money has been created in that notional amount. Most economists teach a theoretical framework that has been shown to be fundamentally useless. -- James K. Galbraith
Say, back in 2004 or 2005 I entered in a (say 5 year) CDS agreement with you. Not owning any of these debts myself I bet that in 2009 or 2010 - for example - GM, Chrysler (Cerberus), Fannie or Freddie Mac, AIG or Lehman Brothers etc. won´t pay its debts?
I´ll pay you $500,000 per year and in case anyone of them defaulted (according to the fine print) you´ll own me $10 million?
The fine print also involves going into government receivership. Certainly true for Fannie and Freddie Mac by now. I invested (2004-2008) maybe $2 million, you now own me $10 million!
The problem seems to be that these CDS contracts weren´t regulated at all. And nobody back in 2004 or 2005 expected a credit crunch just 1-2 years later. They were OTC (Over-The-Counter) contracts. Nobody regulated them, nobody oversaw them.
So I suspect that these CDS aren´t "neutral", we have to expect that they are heavily weighted against at least some companies? Wasn´t that the problem for AIG?
You pay me €100 now and I pay you €1M on some event of probability 1/10,000.
Would you take the bet?
And if you knew I couldn't pay it, would you take it?
And suppose you didn't know better and you still took it and I lost and I couldn't pay? What would happen? Would it be the end of the world?
And at which point in this game is money created? Most economists teach a theoretical framework that has been shown to be fundamentally useless. -- James K. Galbraith
I don't think money is ever created. Debts are created under certain conditions. But the debts can be enormous.
So you are right. The derivatives are not creating money or inflation but potential debts. Under black swan conditions, the debts could be so enormous that repayment is impossible. Which would then lead to potention cascading bankruptcies throughout the financial system....if all is so intertwined as some state. Buffetts financial WMD's.
Money which is hidden from balance sheets and audits can still exist as long as there's some way to convert it into real goods.
The awful toxic horror of money is that somehow these debts become illusory assets which exist for exactly as long as people believe in them.
When that confidence disappears, so does the value.
The only way to avoid a manic depressive economy is to ground value units in items with real physical value - not gold or silver, because their value is mostly still symbolic, but in the products of the ecosystem and in energy flows.
It's impossible to have a viable, stable economy when no one knows how much units of exchange are really worth, or when currency is subject to insane cycles of emotional and psychological excess.
And the real problem is that they may then be accepted as collateral for loans.
This is like what happened with subprime. A NINJA-mortgage salesman comes to an unemployed black man sitting in a porch in rural Alabama and asks him "would you like to own this house before it falls over?" and the man says "sure" so he gets a mortgage he will almost certainly end up defaulting on. But now he's a homeowner! So next time he goes to the bank they ask him "are you a homeowner?" and he ways "yes" and they offer him "how would you like to have a credit card?", so he gets a credit card. And so on. Most economists teach a theoretical framework that has been shown to be fundamentally useless. -- James K. Galbraith
