Are you scared by the $300 trillion derivatives market? Jesse
Eisinger is. Since his piece in Portfolio came out, Jesse and I have talked
about it at some length; he ended up telling me to write a blog entry which
he can respond to. Watch this space for Jesse’s reply!
So. Is the derivatives market scary? In a word, no. That $300 trillion number
– a good five or six times gross world product – is meaningless.
It includes untold numbers of contracts which cancelled each other out years
ago, and it’s based on something called "notional amount" which is
vastly larger than the actual sums of money changing hands. An interest-rate
swap, for example, might pay out the difference between a fixed rate of 6% and
a floating rate of 5%. On a notional $1 million swap, the total payment is just
$10,000 per year.
What’s more, that payment is probably being used to hedge some other kind of
interest-rate risk elsewhere. Most derivatives are not a speculative investment,
but are in fact part of an attempt to smooth cashflows and make unpredictable
markets more predictable. If you’re an airline, for instance, you’d much rather
lock in your fuel prices than be subject to the kind of price volaitility that
jet fuel has undergone in recent years. And if you’re an equities investor,
you can use derivatives to protect you from any stock-market crash.
The fact that derivatives are global is a good thing. Jesse quotes the CEO
of General Re as saying that "a financial crisis is likely to be a global
event, not a local event, and derivatives will probably help make that happen.”
To which I say: great! A problem shared is a problem halved.
It’s worth remembering, here, that the derivatives market can’t crash, in the
way that the stock market or bond market can. It’s a zero-sum game where for
every loser there’s a winner. Theoretically, the net amount of wealth tied up
in derivatives is zero, which means that no wealth can be destroyed by a market
event. In practice, says Jesse, there are some derivatives trades in which both
counterparties mark a profit to market. That seems weird to me, but in any case
the total amount of wealth at risk is confined to such aberrant valuation procedures
within sophisticated financial institutions. If you have money in a pension
fund, you’re worried about securities markets crashing. You really don’t have
any worries at all about valuation risk in the derivatives market.
The great thing about derivatives is that short of a major investment bank
failing, there’s very little systemic risk involved with them. Investors such
as Robert Citron or Brian Hunter can and do
blow up now and then. But all those concentrated losses simply reflect gains
elsewhere in the system. And as for the investment banks, they’re subject to
exactly the kind of regulations which Jesse claims are needed.
Yes, derivatives are difficult to value, and can end up giving an unwary investor
nasty losses. But they perform much more good than harm, in areas from agriculture
to catasrophe insurance. The risks are entirely theoretical; the benefits are