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Derivative Collapse?

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OTC derivatives statistics at end-December 2014

1. OTC derivatives statistics at end-December 2014

Highlights from the latest BIS semiannual survey

of over-the-counter (OTC) derivatives markets:

OTC derivatives markets contracted in the second half of 2014. The notional amount of outstanding contracts fell by 9% between

end-June 2014 and end-December 2014, from $692 trillion to $630 trillion. Exchange rate movements exaggerated the contraction of positions denominated in currencies other than the US dollar. Yet, even after adjusting for exchange rate movements, notional amounts were still down by about 3%.

The gross market value of outstanding derivatives contracts – which provide a more meaningful measure of amounts at risk than notional amounts – rose sharply in the second half of 2014. Market values increased from $17 trillion to $21 trillion between end-June 2014 and end-December 2014, to their highest level since 2012. The increase was likely driven by pronounced moves in long-term interest rates and exchange rates during the period.

http://www.bis.org/publ/otc_hy1504.pdf

Is the derative bubble collapsing with the notional amounts outstading falling by $62tr? Or is this just meaningless?

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"Derivatives" covers a lot of instruments, each based on different underlying assets. Lots of these will be offset against each other as hedging positions, so will be reducing overall risk, rather than increasing it. There's no "derivatives" bubble as such. In fact the derivatives markets help reduce overall systemic risk, up to a point, by spreading risk amongst the market participants.

The big numbers occur due to the nature of how they are used. A farmer may sell $1m of grain futures to lock in a good price for his crop in 6 months. The buyer of the futures contracts may hedge these with options or other futures contracts "worth" close to $1m, and the other party to those contracts may offset their risk in similar ways.

The net result is that each party to the chain of transactions gets to limit their own risk. On paper though, many millions of dollars "worth" of derivatives have been created, ultimately based on the one initial hedge by that single farmer.

Now apply that kind of multi-party "chain" of hedging to every major asset or commodity sale, every large share / commodity and FX transaction, and it's easy to see how many trillions of derivatives are created.

The data isn't entirely meaningless though. The reduction does indicate tightening of liquidity, with less participants and/or trades going on.

The other thing is that whilst derivatives reduce risk up to a point, by spreading risk, there is also the possibility that they could increase systemic risk due to contagion if market participants start to fail. A hedge backed by a bankrupt counter-party is no hedge at all.

Without knowing the makeup of that $630t, it's impossible to know how it would all unwind in a crisis.

Edited by ManVsRecession

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A hedge backed by a bankrupt counter-party is no hedge at all.

Which kind of negates the reason for many of these 'instruments' to exist in the first place.

Do they actually negate risk or just create the illusion of doing so by moving that risk around?

In many ways the entire mindset here is absurd- you have an entire industry predicated on mitigating risk that itself is massively exposed to exactly the kinds of risk it's supposed to mitigate.

It should have been obvious to all concerned that a financial system than ever really managed to eliminate the risk of default would immediately collapse into a singularity of infinite debt since no fear of default = limitless moral hazard in the process of credit creation and thus no limits on how much credit could be created.

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The important point for risk management is that these are OTC derivatives. With some specific exceptions such as currency forwards or standard options that have very transparent pricing I would never trust most derivatives as far as I could kick them. You'll likely get away with it but it's usually cheaper and safer to do it yourself. A good rule of thumb is see who banks are hiring lots of at big money and then stay the **** away from whatever they are doing. Couple of years ago it was all flow for hedging index derivatives - i.e. that's probably basically front running you.

1.) Because some contracts aren't standardised you can't transfer them somewhere else or safely hedge the exposure in an emergency if your counterparty goes bust.

2.) The structure is sometimes bespoke (i.e. point at which it expires) which makes it much harder to track standardised costs and seasonal effects. Price can come in non-standard bits!

3.) Lack of transparency means that they are designed in such a way as to disadvantage you to the benefit of the bank e.g. spreads, charges, yield, etc. - they will scalp them all if you let them.

4.) Silly leverage can produce weird shaped pay-offs in extreme underlying moves, decreases stability and increases hedging errors but lets them charge you more whilst setting aside the same capital (it is classed as a hedged trade).

5.) Unpredictable behaviour at critical events as the bank is often using the derivative to sell off some crap residual exposure in bulk or has some underlying they game. There's often nasty previously unseen tails hidden in it.

6.) Publishing the exact time and markets the derivative will be based on so people can "pre-hedge," the market and make sure you get a terrible price. Goes with (5) obviously. Easy to make a few million a year with good market access and a linear regression algorithm on many funds or ETFs.

7.) Pricing often quoted to you based on a model and a spread rather than based on actual trades ... the actual payoff can detach from this unpredictably and you need to run and understand the model yourself.

8.) No independently verified and audited measures of liquidity and open interest, but will clearly be linked to underlying. Gives the broker a big informational edge on the specific market.

Absolutely none of the above apply to nicely standardised exchange traded contracts with short/long origination by any broker, and a deliverable underlying such as Futures .. I never used to loose sleep when counter-parties went down, as they are a thing of beauty. Obviously ... they are broken by ZIRP, as there is still time risk but it isn't really priced in yield!

Edited by Kinky John

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"Derivatives" covers a lot of instruments, each based on different underlying assets. 02Lots of these will be offset against each other as hedging positions, so will be reducing overall risk, rather than increasing it. There's no "derivatives" bubble as such. 02In fact the derivatives markets help reduce overall systemic risk, up to a point, by spreading risk amongst the market participants.02

02

The big numbers occur due to the nature of how they are used. A farmer may sell $1m of grain futures to lock in a good price for his crop in 6 months. The buyer of the futures contracts may hedge these with options or other futures contracts "worth" close to $1m, and the other party to those contracts may offset their risk in similar ways.

02

The net result is that each party to the chain of transactions gets to limit their own risk. 02On paper though, many millions of dollars "worth" of derivatives have been created, ultimately based on the one initial hedge by that single farmer.

02

Now apply that kind of multi-party "chain" of hedging to every major asset or commodity sale, every large share / commodity and FX transaction, and it's easy to see how many trillions of derivatives are created.

02

The data isn't entirely meaningless though. The reduction does indicate tightening of liquidity, with less participants and/or trades going on.

02

The other thing is that whilst derivatives reduce risk up to a point, by spreading risk, there is also the possibility that they could increase systemic risk due to contagion if market participants start to fail. A hedge backed by a bankrupt counter-party is no hedge at all.

02

Without knowing the makeup of that $630t, it's impossible to know how it would all unwind in a crisis.

this is misleading. derivatives are zero sum, half are short and half are long. If I get levered up 50 times my equity and go long x number of contracts then someone is short by the same amount.In my case, leveraged up 50 times equity, if the underlying (usually rates) moves 2% I am wiped out. Gone. The so called winner, holding the other side of the trade is also maybe wiped out because he has no winnings to collect from insolvent me. And in turn all his creditors cannot then collect from him. On eye watering amounts outstanding , over $600 trillion, with a global GDP of only $50 tn, you can see that quite small moves in rates(they are almost all underpinned by rates) and there is not enough liquidity on the planet to meet the margin calls.

Buffet said derivatives are easy to enter and almost impossible to exit. QE is, I am quite sure, nothing more than the central banks attempting to delay the inevitable systemic bust by printing money to give to derivatives players to meet margin calls.

Nobody knows how to defuse this.

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