The face of the river, in time, became a wonderful book . . . which told its mind to me without reserve, delivering its most cherished secrets as clearly as if it had uttered them with a voice. -- Mark Twain

The Derivatives Time Bomb

Posted: June 12th, 2012 | Author: | Filed under: Uncategorized | 1 Comment »

We need to talk about derivatives.  The market has grown so unfathomably vast, the global economy is at risk of massive damage should even a small percentage of contracts go sour.  Its size and potential influence are difficult just to comprehend, let alone assess.  It is imperative, however, that we begin to understand derivatives, as they were at the heart of the housing bubble that brought the economy to its knees and they remain a looming danger in the world economy today.

The shocking truth is that there has been no effective regulation of derivatives put into place since they brought about financial collapse five years ago.  Even more shocking is that the size of the derivatives market has exploded since that time.  The total notional value, or face value, of the global derivatives market when the housing bubble popped in 2007 stood at around $500 trillion.  New numbers from the Bank for International Settlements (BIS), which tracks the sales of derivatives, shows the Over-The-Counter derivatives market alone has grown to a notional value of at least $648 trillion as of the end of 2011.  However, according to the best estimate of the International Swaps and Derivatives Association (ISDA) the BIS numbers are understated and the market is likely worth closer to $707 trillion and perhaps more.

Now, if you’re not a number junkie type – which I really am not – you can guess seven hundred trillion dollars is a pretty serious amount of money, but you might not completely understand the totally astronomic scale that number represents.  To put it into perspective, we should note that the gross domestic product of the entire world stands at around just 60 trillion dollars.  The US residential real estate market is worth 23 trillion dollars.  The total value of all the US stock markets is a mere 16 trillion dollars.  The value of the entire world’s stock markets is about 50 trillion dollars.  Derivatives currently represent around ninety percent of the world’s financial liquidity.  Unfortunately, in addition to remaining vastly unregulated and opaque, the market for the creation and exchange of derivative contracts operates much like the roulette wheel at a Las Vegas casino.

Derivatives have become instruments that enable banks to gamble with vast amounts of money in order to produce high returns on their investments.  A derivative is essentially a bet.  They were used responsibly in business for centuries as insurance against loss.  For example, in a simple derivative contract a farmer might bet against the success of his own crop to insure that if his crop fails he will not be at a total loss.  If the crop is productive that year, he loses the bet but reaps a profit from sale of his product.  If the crop fails, on the other hand, he can collect on the bet and make up for his loss of profit.  Derivatives provide a way to produce even returns in markets that are subject to uneven productivity.

One of the problems with today’s derivatives market is that it has expanded from its initial purpose of hedging and simple speculation to allow for betting on just about anything financial.  During the housing bubble we saw banks like Goldman Sachs betting on the failure of the very products they were selling as “AAA” rated safe investments.  They made a ton of money on the failure of their own financial products in this way.  (Talk about conflict of interest and moral hazard!)  Today’s synthetic derivatives market even allows for betting on other people’s bets. This has created a multi level ponzi scheme of derivatives that are based on the success of other derivatives, using huge degrees of leverage at every layer.  Today, when a farmer bets against his crop, banks and hedge funds pounce on the opportunity to bet on the success of that farmer’s derivative contract, and then other bets are placed on the success of those bets and so on.  With each bet using leverage to inflate the face value of the contract, we end up with multiple bets that have a combined value exceeding the actual value of the farmer’s crop many times over.

Another problem with today’s derivatives market is that the contracts are so loosely controlled that no one is really sure of the actual numbers concerning its size or structure.  Our government has colluded with Wall Street and the banking industry to ensure there is no central clearing house for derivative transactions, no central reporting and no disclosure.  There is one arm of derivatives sales that does work through clearing houses which record and track transactions, but since the $700 trillion dollar Over-The-Counter (OTC) arm of the market remains unregulated and opaque, an accurate assessment of risk is very difficult to make.

The combined exposure of the nine biggest banks involved in trading derivatives comes in at $228.72 trillion.  These are JP Morgan Chase, Citibank, Bank of America, Goldman Sachs, HSBC, Wells Fargo, Morgan Stanley, State Street Financial and Bank of New York Mellon.  To get a sense of the scope of the derivatives bubble, check out an excellent visual depiction at  Keep in mind when considering the graphics, this number reflects just a third of the total notional value of the global OTC derivatives market.

Warren Buffet called derivatives “financial weapons of mass destruction.”  Brooksley Born, former head of the Commodity Futures Trading Commission, warned of serious economic chaos due to the continued lack of transparency, regulation and basic understanding of the market.  Author and ex-Goldman Sachs insider Nomi Prins warns the banking system is vastly over leveraged and at great risk due to colossal exposure to derivatives.  We are already suffering the effects of a collapse in the derivatives ponzi scheme that almost destroyed the US economy and wreaked havoc across the globe in 2007.  Today we face the possibility of another collapse that could be far worse.  We recently saw the collapse of MF Global and a two billion dollar loss at JP Morgan Chase, both of which were essentially the result of bad bets in the synthetic derivatives market.  These losses only barely represent the tip of the iceberg.

Meanwhile, Treasury Secretary Timothy Geithner continues to make it a priority to keep the derivatives market growing. Basically, there is no other game in town to realize the kind of profits banks and their clients demand these days, so the roulette table is the place to be.  As top deputy to former Treasury Secretary Robert Rubin, Geithner opposed Brooksley Born when she warned of the dangers of derivatives way back in 1998.  Born wanted to create regulations requiring transparency and oversight of the derivatives market, but was viciously blocked by the Treasury Department and then Fed Chairman Allen Greenspan.  Ten years later the lid blew off the ponzi scheme and Born’s anxieties were realized.  The housing market collapsed, bringing the world economy down with it.

More recently, as Secretary of the Treasury to the Obama Administration, Timothy Geithner repeatedly opposed and blocked the efforts of Born’s successor as CFTC Chairman, Gary Gensler, to toughen scrutiny of the derivatives market.  The result is that the market that took down the economy has grown even larger since that disaster.  Wall Street merely left the housing market behind and started betting more furiously on other things, like the failure of the Greek economy, the portfolios of maverick financial traders and who knows what else.

We are facing a ticking time bomb.  The global derivatives situation today is very frightening indeed, but information is power.  I will continue to explore the subject in more detail here at The Paper Boat. Meanwhile, I’ll leave you with this short video series from Harvard Law School Professor and Managing Principal of Cambridge Meridian Group Inc, Jack McMullen.  He offers a very good explanation of the derivatives market and wherein the problems lie.

Casino Royale:  Derivatives and the Financial Meltdown, part 1

Casino Royale:  Derivatives and the Financial Meltdown, part 2

Global Research
Financial Fraud and the Global Derivative Casino
Matthias Chang
June 12, 2012

Bank for International Settlements
OTC Derivatives Market Activity In The Second Half Of 2011
May 9, 2012

The Economic Collapse
Derivatives: The Quadrillion Dollar Financial Casino
December 13, 2012

One Comment on “The Derivatives Time Bomb”

  1. 1 Five Years After The Financial Meltdown, The Water Is Still Full Of Big Sharks : STRATEGIES said at 5:31 am on January 9th, 2013:

    […] Moreover the derivatives market is steadily growing. “The total notional value, or face value, of the global derivatives market when the housing bubble popped in 2007 stood at around $500 trillion… The Over-The-Counter derivatives market alone had grown to a notional value of at least $648 trillion as of the end of 2011… the market is likely worth closer to $707 trillion and perhaps more,” writes analyst Jenny in The Paper Boat. […]

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