That’s a rough estimate of the volume of outstanding contracts in financial derivatives, mainly interest swaps (some year-old and incomplete data here totals $175 trillion). As the name implies, these are usually matched, so that the actual net exposure of any party is a tiny fraction of the gross. But if the counterparty on one side of the swap should default, things could get very nasty. And, given the volume, default on a small proportion of the contracts would overwhelm the resources of the world’s central banks. To get an idea of magnitudes, US GDP is about $11 trillion or 5.5 per cent of outstanding contracts. When Long Term Credit Management went bust in 1998, threatening the stability of the world’s financial system, its gross position totalled $1.25 trillion, or about 0.6 per cent of the amount outstanding today.
Of course, the central bankers and prudential regulators have everything under control, and have simulated all the possible things that can go wrong. As for experimental tests of the stability of the system, we haven’t really had one yet, apart from LTCM. The last time the US financial system came under any real stress was the 1990 recession (or maybe the 1987 crash) at which time the volume of derivatives was maybe $1 trillion.
Still, as Eeyore said in a rather similar situation, “That’s what makes it so terribly interesting. Not really knowing until afterwards”.
John Quiggin 
LOL. It’s quite amazing how much useful life philosophy can be garnered from Winnie the Pooh.
John:
All the serious players in the swap (generic term) markets have mutual offset and margin agreements. When Drexel Burnham Lambert went belly up, the Fed went to all the banks and instructed them to net out outstanding contracts and offset with other banks. Coincidently (or luck) there was no residual negative balance to worry about. With LTCM the same thing happened but at that time mutual margin and offset agreements between the banks were a standard operating procedure as everyone learned from Drexel Burnham. As you mentioned, although the numbers are staggering the net position between the big institutions is not really something to worry about because the system is margined everyday. That’s means if bank A has a margin deficit with bank B beyond a certain risk threshold Bank A will send Bank B funds to cover the shortfall. Of course not all transactions are done interbank (between) banks but between clients and banks. The risk becomes part of the exposure bank credit departments allocate to clients in accordance to Bank of International Settlements guidelines. In the case of an interest rate swap with a client, a bank will have to reserve a certain portion of its capital to meet these requirements. It will be less if there are mutual margining agreements between the bank and the customer.
When that shady Pakistani bank failed (just can’t remember it’s name) BCCI (I think) everyone on the street had positions open with them and if I recall no one lost money. Those banks with surpluses as a result of the net off tendered the funds to the central bank of domicile that who then forwarded that surplus to those central banks having banks in negative balance to the failed bank. Again everything went very smoothly.
If you want to know where all the creaks are in the system look no further than Fannie Mae, Sallie Mae and most importantly the large international insurance companies who seem to take on large credit risk swaps with out much oversight. That is where the real problems reside, not the hedge funds. That is not to say hedge funds can’t go bust, but they won’t bring the system down like those I mentioned above.
One real area of risk that has always concerned me is the US mortagage backed securities markets because they have real peculiar behaviour when there is sudden movements of interest rates. All the large banks have the Math pretty well under control, however the real problem resides with those securities purchased by overseas investors in the US. Because these intruments generally carry an implied US Govt. guarantee, overseas investors are financing the US C/A by purchasing these securities. I begin thwonder if some of them actuall know the risk.
I agree that mortgage-backed securities are more risky than interest-rate swaps,
I wonder how well the swap market would cope with, say, a military coup in China leading to a sudden large-scale sale of US bonds. As you say, the derivatives market is well set to handle a single player going bust for internal reasons, or even because of bad bets. I’m less sure that it could handle two or three simultaneous failures occurring at a time of disruption in the spot markets.
John,
Good questions!
I would guess that multiple failures would certainly test the system, but I think it would cope because of all these set-off agreements etc. However, you could have a situation where the market, say, in the credit spread (the spread between US Govt. bonds and a AAA borrower) blows out so quickly and of such magnitude that people get really hurt. Don’t forget though that Hedge funds, although they carry leverage in their activities, do have underlying equity, which is watched carefully by bank credit departments and that is why LTCM didn’t hurt the banking system despite their massive positions. The people who lost out were the investors to the fund. My rough guess is that multiple failures could be handled ok.
I saw the LTCM failure at ringside and I was amazed how well and how intelligently the Fed managed the entire process. It was staggeringly good leadership. On the other hand though, if they made one mistake, it could have also toppled the entire system. Seriously! So we better hope the Fed continues hiring good people.
Whenever you read the Bloomberg bond market report these you generally see foreigners not buying straight govt. bonds, but “agency” paper, which means they are dipping into the Sallie, Fannie Mae stuff. If you want to look to find where the real leverage is in the US look no further than this market. The thing, which really shocked me, was that last year (I think, or the year before, I can’t recall exactly) the CEO and CFO of one of these two agencies were fired for accounting irregularities. I believe the sum involved was a staggering 6 bill.
I guess if China decided it wanted to sell out of it’s holding they would cause damage to the US system. The effect would be certainly felt in the long end of the bond markets where prices would sink and yields skyrocket. However the other side of that is the Chinese would be incurring massive losses on their positions in addition to losing their export market to the US as a bond price collapse would shock the US economy. Therefore the question becomes why cut off my nose to spite my face? I guess no one can provide a rational answer to this if behaviour itself is questionable.
As I said before the area of concern are the “US agencies� that hold massive balance sheets on an implied (only) US Federal Govt. guarantee (read truly massive leverage) and also insurance companies venturing out and selling all sorts of derivatives which may not be getting the attention this area really deserves.
One last thing: the real risk to the US system in the 80’s and late 90’s was not so much the big banks although they were also problematic. The real problems were the S&L’s. This is where you saw absolute stupidity caused by Government intervention demonstrating all good intentions but not understanding the consequences. Savings and Loans had the asset side of their balance sheet protected – insured by the Federal Govt Insurance Corp. (approx name as I don’t exactly recall)- but were relatively unregulated in their lending activities. This initiative (half- side deregulation) was the stupidest thing the Reagan did. The final bill came in at around 250 (bill). I think the two agencies are going the same way, but only bigger.
One of the strange things in the swaps market is that there is no factoring into the pricing for the riskiness of the counterparty. Of course its small compared to a bond, but to ignore it altogether always seems strange to me.
There is a possibility that all the risk management modelling is a bit like a tight right walker suspending his safety net from the pole he’s carrying.
Steve,
Counterparty risk is factored into the pricing – where it is material. In most cases, as you noted, it is small. Even on a $100,000,000 position the actual amounts exchanged can be in the thousands per month so even a major default (provided there is not much movement in the underlying) does not give rise to much in the way of changed cashflows.
Just as a side comment to this – wait until the new accounting standards require the disclosure of these positions in annual reports over the next year or so. Should make some fascinating reading.
On topic, though. Most of the corporates I have worked with over the last year are not using swap (or other derivatives) for naked speculation – they are doing it to hedge their own positions. A swap is a great way to borrow in the most effective way and then arrange to pay for the debt in the way that best suits the company. Where it is done correctly these are great tools.
Like any tool, though, when mis-handled, they can hurt. I am not aware of anyone going down due to swap positions, though – it is normally forwards or sold options.
“On the other hand though, if they made one mistake, it could have also toppled the entire system. Seriously! So we better hope the Fed continues hiring good people.”
Doesn’t inspire me confidence that the system is safe.
“Therefore the question becomes why cut off my nose to spite my face? I guess no one can provide a rational answer to this if behaviour itself is questionable.”
The Chinese are the people who gave us the Great Leap Forward the Cultural Revolution. Anything is possible, especially if there is serious argument over Taiwan.
The regulation of the derivatives market is yet another example of fighting the last war. Things happen – The S&Ls, Orange County, Barings, LTCM – the regulation ratchets up a notch to try to ensure that what specifically happened in the past won’t happen again, and then something different happens.
The scary thing is, no one really knows whether we’re at great risk or not, let alone how to manage the risk.
Andrew,
Somewhere someone might be adjusting pricing, say for dealing with sub investment grade. In my experience in Aus banks in front office they don’t even on very large face values. At inception the adjustment to pricing is small, it can get signifigantly larger if there is a signifigant move in rates and the positions have largish exposures.
I also agree though that the risk on swaps causing a catastrophy is small, compared with other derivatives.
Sould the billion in the fourth line actually read trillion? I don’t understand this stuff, but it seems consistent with the rest.
David:
You are quite right there is risk is the system we have’t yet seen or understood. But that is how one part one human knowledge progresses. In other words we learn from our mistakes. This becomes circular because a mistake or accident sometimes has to happen first before we understand it.
Probablity theory can be understood by this example. No matter what weighting you attach to some risk there is always an unforseen risk you do not see coming at you at 100 MPH. No one thought thought black swans existed until the Europeans set foot in Australia: and guess what, there were black swans.
All this means is that we ought to get out of bed in the morning despite an unforseen risk.
1. Huge nominal positions boil down to very small net exposures, margined frequently, in the main.
2. Watch out for ABS hedging survey results for a view of FX exposures…. data collection is underway.
3. Derivatives markets are effective as one mechanism for arbitraging risk. Most alternatives are less effective?
4. Asset backed securities markets, at least in Australia, require risk reduction through credit enhancements eg to bring mortgages up to risk rating of investment grade securities). These are delivered in the main through derivative products, like credit swaps. Historically, the credit enhancements were provided by explicit government subsidies, and implicit “backing” from government. Explicit subsidies are out of favour (don’t try and pick winners) and implicit backing was found not to be worth the paper it wasn’t written on.
5. Military coup in China, North Korea move on the south or Japan, etc etc would test all social and economic structures based on “business as usual” assumptions, not just derivatives markets. So these shouldn’t be singled out.
6. Will the new accounting standards (IFRS) promote more transparency in reporting derivative risk? Will IAS 39 be adopted fully by all?
Actually, the black swan example is a very good one of people anticipating the unknown. A 19th century philosopher used the idea as an example of what we did not know as against what we knew did not exist; he pointed out that such things might very well exist in as yet unexplored areas. The actual discovery confirmed his point but rather took away the force of the example. But either way, it is not an example of something totally unforeseen that turned out to exist after all. Also, if you ever take a look at them you will see that they are actually a very dark brown with some touches of colour. They attracted the name “black swan” from previously existing ideas about the fowl.
Jesus PM, I’ve been living here in WA for all these years and now you are telling me the Black Swans are really Brown. I am definitley going to take a closer look next time I am close enough.
S Brid – you have really put the chickenlitllers in their place on this one – well done.
Interesting to note that Kimbo has started going off about how bad our domestic debt is!! (Anything to try and get away from his tax-cuts debacle). If the poor lad is worried about the domestic debt, just don’t tell him about the Swaps market debts – his head might explode.
Well, I’m thinking dark brown of one particular one I saw in the Melbourne botanical gardens some years ago, which I would call dark brown in comparison to (say) the black of a really black cat. But that’s my subjective judgment; others might call it black.