PrepperNomics 107:  Derivatives are going to destroy the World!! (Or, Not)

We’ve all seen posts on forums and other references talking about how huge the Derivatives Market is and how supposedly dangerous it is.  The amazing thing to me is the folks posting, clearly don’t know what a derivative is.  Despite that impediment, they have no problem concluding the derivatives are all going to go bad at the same time, bringing destruction to all of us.  Usually, the folks trying to scare you into doing something are trying to sell you gold, or their book on how to avoid the next financial crisis. ☹

A derivative is simply a contract, based on an underlying financial product.  The derivative you are most likely to be familiar with is Foreign Exchange, simply exchanging one currency for another country’s currency.  Foreign Exchange can be an immediate exchange, or set to occur on a future date.  The underlying financial product is the currency involved.  Foreign Exchange is necessary for international trade to take place.  The more international trade there is, the more Foreign Exchange.

However, “derivatives” also include Options, Futures, Forwards, Swaps and other instruments.  One problem with the huge numbers about the “size” of the derivatives market is that the term “derivatives” includes lots of different kinds of contracts.  These contracts do not all operate in the same way, and would not move in a synchronized manner.  The term “derivatives” is not merely a mixing of apples and oranges, but more of a fruit salad.  😊

The Concept of Risk

In finance “risk” means something slightly different than what it does when we use the word for day to day non-financial events.  In day to day usage, risk is generally a measure of something negative, e.g. “What is the risk we will experience a hurricane?”  When applied to financial products, risk is a measure of price movement.  That movement could be up, or down, in value.  For instance, the stock market might go down, but it also might go up.  Financial risk is a measure of movement in either direction.

Derivatives usually are used to transfer risk from one party to another.  For instance, let’s say I am a US manufacturer of widgets, and I enter a contract to supply widgets over the next year to a European customer.  The contract is in Euros.  I don’t want to worry about the US dollar vs. Euro price moving while I am building widgets, and waiting to get paid, so I can go to my bank and enter a Foreign Exchange contract to exchange my Euros for dollars next year.  The exchange rate could go in my favor or against me, but I am willing to forego the possible upside to eliminate the downside risk.  My risk of price movement is now gone, as I have eliminated the risk of the price moving either favorably or unfavorably.  Where did that risk go?  It went to the bank I entered the futures contract with.  Why would the bank do this?  The bank has customers who want to do the opposite of what I want to do.  As a banker, I have my US customer who wants to get rid of Euros, but I may also have a European customer who wants to get rid of US dollars.

As a banker, I can do foreign exchange contracts with both of them, and by maintaining a slight price difference called “spread”, make some profit while essentially netting the bank’s risk.  While one contract might lose money, the other will gain.  Let’s say these contracts are each for $1 million, and the price moves by 10% over the time of the contract.  One contract will lose $100,000, but the other will make $100,000.  Meanwhile if someone asks how much does the bank have in foreign exchange futures contracts, the answer is $2 million.

People who express concern about the derivatives market “going bad” are thinking that somehow $2 million dollars is going to be “lost”.  However, if a year from now these contracts are completed and everyone has the currency they want, the amount of foreign exchange contracts will have shrunk by $2 million, even though no one “lost” anything.  On the other hand, if the bank is able to write new contracts for twice as much foreign exchange, the amount of Foreign Exchange contracts reported will move from $2 million to $4 million.  Did someone make an extra $2 million?  No.  The only profit or loss is the small spread the banker makes for facilitating these transactions.

Scale of the Derivatives Market

The Foreign Exchange Market alone dwarfs the stock market in scale.  While “derivatives” also includes the markets for Options, Forwards, Swaps, etc.

Furthermore, since a derivative is a contract, the opposite sides of a derivative product will not both fail.  If one side is going up, the other is going down.  The derivatives are double counted because the “market” includes both sides of the contract.  Both sides are counted in the aggregate numbers, which are taken from the regulatory reports filed by major financial institutions, so if one side has a $1 million contract, then the opposite side has a $1 million contract, which gives us a $2 million market despite the fact there is only one $1 million contract in existence.

Also, the size of a derivative is based on a concept known as “notional value”.  That’s where the $2 million figure comes from, even though there is nothing like $2 million at risk.  The contract’s value is actually the small spread the bank makes.  Notional value is not the same as market value, which is how securities, loans, or other financial instruments, are measured.  Notional value is an attempt to translate these contracts into some measure of the amount of business being done.  The numbers can be really scary in the hands of someone who has no idea what he is talking about.  For instance, let’s say we have a bank with a $100 billion balance sheet.  However, the bank has a $1 trillion, notional value, of Foreign Exchange contracts for future delivery, offsetting each other as above.  Then someone who has no idea of what we have just discussed asks “What if the $1 trillion of contracts “goes bad”?  😊

The Actual Risk in the Derivatives Market

Since the notional value has nothing to do with risk, we might want to ask what other risks exist within the derivatives markets.  The primary risk is failure of the party on the opposite side of the contract.  If I am that manufacturer above, with my Foreign Exchange contract with Bank XYZ and the bank fails, I would appear to have a problem.

This is sort of like having a contract with a plumber to fix your toilet and the plumber goes out of business.  In the case of derivatives there are two things that mitigate this risk.

Many of these contracts have daily Margin requirements.  Margin is essentially good faith money to insure your contract will be paid regardless.  In other words, if you are on the losing side of a contract, then you will need to put up margin to cover the potential loss.  Your Margin requirement can go up one day and down the next.  As a result, if a party goes out of business, any loss up to that point will be covered by the Margin.

The other factor is that a contract that isn’t fulfilled can simply be replaced by a contract with a new party.  If your bank goes out of business, you are covered from losses up to that point by the Margin, and then you simply go to another bank and enter a new contract, just like you can go out and get another plumber.

Why Do People Think the Derivatives Market is Risky?

Obviously from what has been said already, lack of understanding of the terms and products is a major factor.  Another factor is that during the financial crisis, the major culprit was federal requirements to write very risky mortgages.  It was in the interest of the government to blame someone else, and the banking industry became the favored target for blame.  The result, was the Dodd-Frank Act, which became a dumping ground for every financial regulator’s pet new “reform”.  One of those areas was the derivatives market, where some changes were made, but much less than you might expect based on the ink spilled on the subject.  This gave the impression to the general public that this was an important problem, even though most members of the public don’t know what derivatives are.  (For more on this read “Hidden in Plain Sight” by Peter Wallison.)

Can derivatives be risky?  All you need to do to create risk is enter a bunch of contracts that are all in the same direction, and do not offset each other, to create risk for yourself, or your business.  However, the market as a whole is not risky, because for every loser there is a winner, and most financial institutions understand the risks involved.  In addition, the regulators are all over these products.

Summary

There is risk in financial services products, but most derivatives are used to move that risk from one party to another party, who can offset the risk with another contract.  Risk is transferred, but not created or eliminated.  The concept of “notional value” makes the market seem dramatically larger than it actually is, and the failure of a financial institution is not a disaster for customers, who simply pocket the Margin and enter a new contract with a different institution.

When someone tells you that the derivatives market is umpteen bazillion dollars, and it is going to send us into an Economic Collapse, ask them what a “derivative” is.  If they can’t answer that it is a “contract based on an underlying financial product”, you’ll know they don’t have a clue.