You know it when you don't see it.

In the long run, we're all dead. John Maynard Keynes

and a simple and appropriate explanation of what liquidity means and why it matters.

Thanks.

In the long run, we're all dead. John Maynard Keynes

With a hat tip to Drew for pulling my tongue on IM.

It'd be nice if the battle were only against the right wingers, not half of the left on top of that — François in Paris

I'm not enough of a mathematician to fully comprehend this, but it seems to be a bit like the reverse of Newtonian mechanics.  Newtonian mechanics works well at the macro level but breaks down at the level of sub atomic particles where quantum mechanics is required to explain observed behaviour.  

The linear mathematics Migeru refers to works well at the micro level, in a liquid market, but breaks down at the macro level when everybody, or a significant proportion (= <1% of the total population) are trying to do the same thing.  Its a bit like trying to approach the speed of light - prices inflate/deflate exponentially/astronomically as the total volume of transactions approaches total market size.

This isn't rocket science, and it should be possible to predict the behaviour of prices as the proportionate of the market seeking to liquidate/invest rises significantly.  It should also be possible to draft regulations which prevent the linear algebraic assumptions of "non-herd like" buyer/seller behaviour leading to inflated asset valuations and the "multiplier effect" that that can have on the total value of derivatives outstanding.

It should have been obvious to everyone - bankers, regulators etc. that there is no way that Derivatives valued at 2 to 3 times Global GNP can be outstanding at any one time.  So was everybody playing chicken?  Blinded by pure greed? Convinced they could defy gravity?  Or just playing with other people's money and banking fat bonuses all along the way?

It would be criminal for an individual business to inflate the value of their business for the purpose of persuading investors to pay unrealistic prices for their shares.  Somehow the rules of accountancy and book keeping are going to have to change to take account of the cyclical and non-linear nature of pricing behaviour in the real world.  At least Microsoft has a solid business model and fairly predictable costs and revenues, but these people knew they were trading in junk.

"It's a mystery to me - the game commences, For the usual fee - plus expenses, Confidential information - it's in my diary..."

Short, sweet and to the point.

The Hun is always either at your throat or at your feet. Winston Churchill

A term that comes to mind when I think of situations like this is "transaction externalities", a character string that retrieves fewer than 100 links via Google. I will boldly and irresponsibly ignore whatever wisdom those links might yield, and instead spit out some thoughts on a  half-baked idea that has been nibbling at me, or vice versa.

Externalities are a standard justification for regulations that tweak or stomp on a market. In the discussions I'm familiar with, however, "externalities" result from actions -- emitting pollutants, creating knowledge, etc. -- but not from market transactions per se. (First problem: How clear is this boundary? Clear enough to be useful, I think). In this category I would like to include the creation of financial instruments, perhaps using the excuse that they are promises of transactions.

The simplest argument for the benefits of trade is that both parties have a (rational?) expectation of gain. The notion of transaction externalities complicates this.

Examples of what I think of as "transaction externalities":

1. The transactions that led to the current derivatives nightmare created systemic risks: These are externalities in that they aren't reflected in the expected benefits to individual buyers and sellers.

2. The purchase of gasoline by a US driver increases US dependency on Middle Eastern oil, and the perceived risks (and responses to them) have engendered enormous costs that are not reflected in the price at the pump.

3. Shopping at a new Walmart, rather than a local or more responsible store, creates costs in the form of economic displacement, loss of valued local institutions, public health care burdens, etc., again not reflected in the immediate costs seen by the transacting parties.

Example (3), however, points to "transaction externalities" of sorts that tend to support broad and distasteful arguments against innovation and market adjustment. Somewhere in the implied spectrum of concepts are ideas that smack of sellers having a right to their customers continued business.

Is there a (semi-)coherent idea to be found here? Is there a sound part called "X" in the literature, or a bogus part that is called the "Fallacy of Y"? And what does "transaction externality" already mean, anyway? (I'm too lazy to read about it at the moment.)

Words and ideas I offer here may be used freely and without attribution.

An insightful diary!

It relates to another little conundrum I've been thinking about since I read a recent piece about art as a long-term store of value and the current activity at the major art auction houses.

In 2006 David Geffen sold a Jackson Pollock drip oil painting called 'No 5, 1948, for a bit over 140 million dollars. That is about the same as the 'value' of the contents of a fully laden Suezmax oil tanker.

Of course you will not get quite the same energy value if you burn a Pollock.

What DO you get out of it? How come an oil painting by an alcoholic, produced during a narrow period of 4 career years, is worth 140 million dollars 50 years after his death?

At the time of its production the painting was not worth much. Apart from the cost of a large piece of fibreboard,  a few gallons of industrial paint and the alcohol, (the down payment on his studio came from Peggy Guggenheim) where is the value?

With hindsight, one can say that Pollock had a unique set of experiences and influences that fed into Jack the Dripper's assault on painting. He worked from 1938  - 1942 supported by the Depression-derived Federal Art Project. He was also intellectually robust enough to figurehead the Abstract Expressionist movement, marry another important painter (Lee Krasner), and have Guggenheim as a patron. But 140 million?

No, the current price of a Pollock is not about the history of fine art - it has been talked up by a market of gallerists, critics and investors (and the media). The millions of words written about Pollock have multiplied his value. Pollock is a myth - like the 172 trillion derivative value.

And the only artefacts of this myth are a few paintings with complete provenance.

In 2006 a documentary, 'Who the Fuck Is Jackson Pollock?', was released which featured a truck driver named Teri Horton who bought what may be a Pollock painting worth millions at a thrift store for five dollars.

Pollock had a profound influence on art: but the monetary value of that that influence was 'talked up' - like the derivatives.

You can't be me, I'm taken

So, realistically, how many Illinois-shaped cornflakes could we buy with all these derivatives?

Be nice to America. Or we'll bring democracy to your country.

I think we should first make everybody aware that the number is misleading !!

"derivatives" is a broad category of contracts, which includes the "plain vanilla interest rate swap". And I can assure you (and you can double-check in the reports of the Offices of Thrift Supervision and Comptroller of the Currency) that between 80% and 90% of the notional amount you quote is just "plain vanilla interest rate swaps".

Why so much ?

• because they are long lasting contracts (each signed remains outstanding for several years)
  
• because all banks and brokers use them extensively to manage the Asset-Liabilities of their balance sheet (ALM). And I mean very extensively, all future cash flows tend to be hedged against rate moves (the losses resulting from a motion of the rate curve are spread between all market participants, and it's a 25-years system that works very well, fully tested).
  
• to the extent that 80% of the positions in a typical trading portfolio are just plain vanilla IR swaps.

It is very easy (and desirable !!) for the notional amount of IR swaps to reach the value of all outstanding debt on Earth, because all debt is on the book of a bank, which practices ALM to spread the IR risk with colleagues. And all outstanding debt is worth something on the same order of magnitude as all existing assets, which is much bigger than world GDP (many assets amortize over much more than a year, real estate being the most typical, so accumulated wealth is much large than one year of output). Of course, this value is somewhat magnified by the marginal pricing effect, and US RE will take many, many years to recover in value precisely because of this effect.

What everybody should understand is that there is very little risk involved with plain vanilla swaps. The swings in their market value is near-linear, well understood, and there are MtM and monthly netting agreement between all major parties. One big boy's collapse will NOT trigger a domino effect through vanilla swaps (it could through credit default swaps, but that's another story).

Remember how a plain IR swap works:
Two parties swap the cash flow associated with a theoretical debt of N $ (N is the notional), whether it's a fixed rate or a variable rate (with a set calculation formula).
They never exchange the notional.
The book value at signature is adjusted to zero, it moves negative or positive only when IR change (and remains typically within a few percents of N).
The total amount of netted cash that will change hands between the two parties is also like a few percent of N, over the many years the contract will stand.

Pierre

if so you have to re think your analysis a bit. (at least this bit:

How can there be $172 worth of derivatives? That's between two and three times the world's GDP and about 17 times the US' GDP. How did it come to this and what can happen if they are found to be worthless"

For example Microsoft options.  There are a gazillion open, but for every long there is a short.  The liquidity trap still exists though as if someone does a Kerviel and has a huge wrong position (and done away from regulators and/or with insufficient credit checking/margining) big enough to sink the bank, you can destroy the system.