Sorry for the lack of Posts last week as I was on a cruise with bad internet. This is the mega-issue that will take down the banking system.-Lou
Derivatives Market a $1.2 Quadrillion Time Bomb
Financial jargon is often arcane and perplexing to the average person. While even casual observers have surely heard of derivatives, most are unlikely to know what exactly they are.
Derivatives, or swaps, are basically bets between companies and banks that are designed, in essence, to be insurance policies.
The problem with derivatives is that since they often involve highly leveraged bets, they can be very dangerous. A small change in market conditions can mean huge losses.
Such losses can occur because derivatives use extraordinary leverage, or borrowing. Derivatives allow investors to earn large returns from small movements in the underlying asset’s price. However, investors can also lose large amounts if the price of the underlying asset moves against them significantly.
In fact, derivatives were used to conceal credit risk from third parties while protecting derivative counterparties, which contributed to the financial crisis in 2008.
That threat still lingers today. If interest rates were to rise unexpectedly, for example, it could result in a financial bloodbath on Wall Street.
Derivatives are used to make the really big money on Wall St. They can be many things, but are basically contracts or bets that derive their value from the performance of something else — an interest rate, a bond or stock, a loan, a currency, a commodity, virtually anything.
For traders, derivatives are a perfect product. They can also be highly lucrative to financial institutions. Over the last five years, banks earned an estimated $20 billion selling derivatives just to school districts, hospitals, and scores of state and local governments across the country.
Yet, as Warren Buffett famously stated, derivatives are “financial weapons of mass destruction.”
The global derivatives market is highly complex, totally unregulated and freakishly large. According to one of the world’s leading derivatives experts, Paul Wilmott, who holds a doctorate in applied mathematics from Oxford University, the so-called notional value of the worldwide derivatives market is $1.2 quadrillion.
A quadrillion is an incomprehensibly massive figure: 1,000 times a trillion. The market’s notional value is 20 times the size of the global economy.
The annual gross domestic product of the entire planet is between $50 trillion and $60 trillion.
Even if Congress decided to regulate the stunningly massive derivatives market, regulators wouldn’t be able to assess the risks of derivatives because they don’t understand them. Congress doesn’t understand them either.