Billion-Trillion Derivatives Market! ... Reform or a Blowup?

Derivatives Reform on the Ropes ... New rules to regulate derivatives, adopted last week by the Commodity Futures Trading Commission, are a victory for Wall Street and a setback for financial reform. They may also signal worse things to come ... The regulations, required under the Dodd-Frank reform law, are intended to impose transparency and competition on the notoriously opaque multitrillion-dollar market for derivatives, which is dominated by five banks: JPMorgan Chase, Goldman Sachs, Bank of America, Citigroup and Morgan Stanley. – New York Times

Dominant Social Theme: We have this billion trillion market under control. Don't worry.

Free-Market Analysis: Derivatives reform? We hardly think so ...

First of all, nobody knows how big the derivatives market is and no one knows how many dollars are at risk. Those involved in making the regulations are also the largest players in the market. Whatever "reform" is being worked out will benefit those who are part of the industry.

Here's how Wikipedia describes a derivative:

A derivative is a financial instrument which derives its value from the value of underlying entities such as an asset, index, or interest rate--it has no intrinsic value in itself. Derivative transactions include a variety of financial contracts, including structured debt obligations and deposits, swaps, futures, options, caps, floors, collars, forwards, and various combinations of these.

To give an idea of the size of the derivative market, The Economist magazine has reported that as of June 2011, the over-the-counter (OTC) derivatives market amounted to approximately $700 trillion, and the size of the market traded on exchanges totaled an additional $83 trillion. However, these are "notional" values, and some economists say that this value greatly exaggerates the market value and the true credit risk faced by the parties involved. For example, in 2010, while the aggregate of OTC derivatives exceeded $600 trillion, the value of the market was estimated much lower at $21 trillion. The credit risk equivalent of the derivative contracts was estimated at $3.3 trillion.

Still, even these scaled down figures represent huge amounts of money. For perspective, the budget for total expenditure of the United States Government during 2012 was $3.5 trillion, and the total current value of the US stock market is an estimated $23 trillion.

The world annual Gross Domestic Product is about $65 trillion. And for one type of derivative at least, Credit Default Swaps (CDS), for which the inherent risk is considered high, the higher, notional value, remains relevant. It was this type of derivative that investment magnate Warren Buffet referred to in his famous 2002 speech in which warned against "weapons of financial mass destruction." CDS notional value in early 2012 amounted to $25.5 trillion, down from $55 trillion in 2008.

Perhaps the most important part of this Wikipedia article (and admittedly Wikipedia is not definitive and often inaccurate) is this statement:

Proportion Used for Hedging and Speculation ... Unfortunately, the true proportion of derivatives contracts used for legitimate hedging purposes is unknown (and perhaps unknowable), but it appears to be relatively small. Also, derivatives contracts account for only 3–6% of the median firms' total currency and interest rate exposure. Nonetheless, we know that many firms' derivatives activities have at least some speculative component for a variety of reasons.

Not knowing how much of a billion trillion dollar market is unsecured and speculative would seem to be a problem. It is a problem because the derivatives market is not a normal market as the securities industry is abnormal, constrained by regulation and fattened by incredible amounts of fiat money.
Nothing like the modern money industry would exist without big government support and central bank monetary stimulation.

Because Wall Street and the City in particular are abnormal industry enterprises, the derivatives market itself is artificial and sooner or later apt to deflate unless one believes that trees can grow to the sky, eternally. But nothing goes up forever.

In the 1980s, portfolio insurance was supposed to insure that counterparty risk was a thing of the past. The Crash of 1987 put that incorrect assumption to rest and those who had depended on those instruments lost billions. There is no such thing as a "sure thing," and no regulatory oversight will adequately supervise or diminish the risk posed by a billion trillion dollar market. Even the New York Times recognizes this:

In the run-up to the financial crisis − and since − the lack of transparency and competition has fostered recklessness and instability. But banks like opacity, because their outsized profits depend on keeping clients in the dark about what other clients pay in similar deals. Under the Dodd-Frank law, derivatives are supposed to be traded on "swap execution facilities," which are to operate much like the exchanges that exist for equities and futures ...

The initial proposal ... called for derivatives trading to take place on open electronic platforms. The final rules will allow much of the negotiation over derivative prices to take place over the phone, a practice that is difficult to monitor and prone to abuse.

By themselves, these new rules are not fatal to the overall reform effort. And they are the best that the commission's reform-minded chairman, Gary Gensler, could achieve at this time because of resistance to tougher standards by the agency's two Republican commissioners and by one of its Democratic commissioners, Mark Wetjen.

The problem now is that Mr. Gensler's term has officially ended, and he is expected to leave the agency at the end of the year. Given Wall Street's incessant lobbying and powerful presence in Washington, it is assumed that he will be replaced by a chairman who is friendlier to Wall Street. That bodes ill for rules that have started out weak and need to be shored up later. To lose a reformer would also reflect poorly on President Obama, but he has not yet shown interest in keeping Mr. Gensler in the government.

This last paragraph refers to something called "regulatory capture." It is one reason why consumers should not count on regulation to protect them. Inevitably in modern governance those who are begin regulated end up in control of the regulations.

The CFTC is a notoriously weak regulator in any case and to further complicate matters US derivatives regulations are not being applied overseas. A lack of transparency, regulatory capture and a regime that ends at the water's edge means that the regs now being put in place for derivatives would seem to be virtually useless. In any event, regulations cannot stabilize a market in advance of a destabilizing event. They are price fixes that transfer risk and wealth from one place to another.

So what is the average investor to do? Given the amount of money pouring into stock markets, it is evident and obvious that averages will continue to move up in the long or short term. Eventually markets around the world will move back down – and no one actually knows when – but it is likely that time is not now.

For those who want to participate in the "only game in town," given that central banks control money printing, US stock markets in particular must present a tempting target. They will likely inflate further.

But those who want to expose some funds to stocks ought to keep in mind that what goes up can come down. Rigorous diversification is surely called for. Cash and precious metals ought to compete with any equity exposure. And it is possible that one ought to consider taking the initial investment out of the market over time, while leaving in the appreciation. This way the risk – and there is a billion trillion dollar risk to be concerned about – will be lessened.

Conclusion: Central banks are apparently determined to lift markets higher with money printing, at least in the short term. Those tempted to play the game – and it can be a profitable one – will remember the risks as the mainstream press is not apt to present many reminders.

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