Why the Risks in the Derivatives Market are Often Overblown
Doom pornographers often enjoy posting terrifying tweets of the monstrous Jupiter sized derivatives market. The bubble boys love to post how any day now one of these banks with too much exposure to derivatives will blow up. I like to point out that while there are some shadowy blackbox like areas in the derivatives market, these fears are mostly overblown. The derivatives market isn’t as enourmous as many are led to believe.
The size of the global derivatives market is difficult to estimate with precision, as it involves a wide range of financial instruments and contracts, including both exchange-traded derivatives and over-the-counter (OTC) derivatives. The following chart from the Bank for International Settlements, BIS, probably best depicts the size and structure of the global derivatives market.
The notional amount $632 trillion of derivatives contracts outstanding is significantly larger than the gross market value at $18.3 Trillion. The reason for this difference is that the notional amount represents the nominal or face value of the underlying assets that the contracts are based on, while the gross market value represents the market value of the contracts at a particular point in time. To understand it better, the actual market value of those contracts at the time was $18.3 trillion, which represents the amount that all the counterparties would owe to each other if all outstanding contracts were to be settled immediately at the prevailing market prices.
The notional amount is often used as a reference point for measuring the size of the derivatives market, but it can be misleading because it does not reflect the actual market value or risk of the contracts. The gross market value is a more accurate measure of the market value and risk of the contracts, as it reflects the current market price of the underlying assets and the terms and conditions of the contracts.
The next point is that the vast majority of derivatives are just interest rate related swaps between banks. These are used for hedging purposes and not really at all for speculative purposes. Of course if interest rate derivatives make up most of the total value of outstanding derivatives contracts at any given time, then if rates move higher suddenly we get more vol and risk over the course of that process. The LIBOR-OIS spread is a good measure for vol with regards to interest rates. Whenever a spread increases so does the risk.
“The difference between the London Interbank Offered Rate (LIBOR) and the overnight indexed swap (OIS) rate, which is a measure of the expected overnight interest rate.” Unlike LIBOR, which is based on estimates from a panel of banks, the OIS rate is based on actual transactions and is considered to be a more reliable indicator of the true cost of borrowing and lending funds in the interbank market.
The global derivatives market is often portrayed as a risky and unpredictable market with a potential for a catastrophic meltdown, but this portrayal is largely overblown. While there are some risks associated with the derivatives market, these risks are for the most part manageable.
Sources:
OTC derivatives statistics at end-June 2022, https://www.bis.org/publ/otc_hy2211.htm, (30 November 2022), accessed on March 20th, 2023.
US FRA minus OIS Spread, https://en.macromicro.me/charts/45928/us-fra-ois-spread, (2023), accessed on March 20th, 2023.
