Derivatives: The Anti-Money
Researchers at CERN, the European Organization for Nuclear Research, in Geneva, Switzerland, made a splash recently with the “discovery” of the Higgs boson — a subatomic particle thought to be one of the fundamental building blocks of all life. The Higgs boson was not actually found, mind you. What was found was a hint of the Higgs boson, because the particle itself is so difficult to measure. For physicists, its discovery is a big deal as it promises to complete the Standard Model theory of physics creating a vital link between matter and anti-matter.
For researchers at CFA Institute, the Higgs boson discovery is interesting because it parallels a great challenge facing the world of finance: derivatives. You see, in finance, derivatives contracts are kind of like the Higgs boson as they contain the vital link between money and anti-money.
What does anti-money mean? In today’s modern banking system, the Federal Reserve creates money — dollars, cents, coinage, etc. This is known as the monetary base. Then the banking system expands the monetary base many times over by creating credit (i.e., loans) — effectively lending out more money than they actually have in their vaults (also known as fractional reserve banking).
Once the monetary base is expanded, it then becomes the money supply. Because the money supply is a function of bank loans, the money supply itself is constantly subject to aggregate changes in credit. So, the performance of loans, net issuance of loans, as well as the rise and fall of aggregate credit have an impact on the money supply. As aggregate credit expands, the money supply expands. Likewise, as aggregate credit contracts, the money supply contracts — all else being equal. Therefore, if a large enough amount of obligations came due simultaneously, then it would cause the money supply to contract — hence, anti-money.
So, in a catastrophic credit event, the obligations spawned by derivatives contracts would cause the money supply to shrink in a material way.
Alas, all else is not equal. The Federal Reserve actively tries to manage the money supply in part by expanding credit. So, whether or not central banks can manage the excess debt is a big question. A bigger question still is whether or not central banks can manage the impact of obligations spawned by the massive derivatives market in a catastrophic credit event. Little wonder that derivatives are now the single greatest concern for professional investors (see a recent survey of CFA Institute members as highlighted in “Derivatives Danger“).
Central banks, of course, are not the only reason that governments have excess debt. As outlined in “Competitive Currency Devaluation: The Feeding Frenzy,” countries like the U.S. have had ever greater trade deficits and are now carrying enormous fiscal deficits. In addition, the world’s accumulation of debt has been absolutely enormous, with total outstanding debt now pushing $200 trillion. Amazingly, the aggregate outstanding debt pales in comparison to the amount of outstanding derivatives. According to the Bank of International Settlements (BIS), the aggregate amount of outstanding OTC derivatives is $707 trillion as of June 2011.
Notional Value of Outstanding OTC Derivatives ($ in Billions)
Source: Bank of International Settlements(BIS).
Of course, this only captures what has been reported to the BIS. Various other sources set the figure at more than a quadrillion dollars when both the listed derivatives and OTC derivatives are included. And because we have no practical experience dealing in quadrillions, we need some context for these mind-boggling amounts: If you had a quadrillion pennies stacked up, it could reach from the Sun to the outer reaches of our solar system.
According to research published by the Federal Reserve Bank of Dallas in 1998, the reason behind the explosion in derivatives was due to the world exiting the gold standard in 1971. Once the “free currency exchange” system was adopted, there was a substantial increase in volatility, particularly with respect to interest rates. Interestingly, in this same paper, the author argues that derivatives do not merit special attention, citing that past events, such as the bankruptcy of Orange County, did not spawn a catastrophic collapse. And, before that horrific crash in Lakehurst, New Jersey, the Hindenburg successfully completed a round trip to Rio de Janeiro. Simply put, “it hasn’t happened before” is not an argument — it’s a cop out.
Moreover, the world is now grossly overindebted, meaning that most governments have little to no room to paper over problems with more debt. So, it is at least conceivable that various government actions to arrest the debt crisis by printing more money could lead to inflation and/or declines in economic activity. What probability this outcome has is anyone’s guess, but it is clearly nontrivial given the staggering amounts of debt and pervasive government deficits. And it is such a decline in economic activity that could set in motion a daisy chain of events causing massive growth in obligations that need to be met — or anti-money.
So, what can be done about this problem? For starters, the aggregate amount of outstanding derivatives on a specific underlying asset should be capped such that the aggregate obligations spawned by a specific set of derivatives cannot exceed the value of the underlying assets. As cited above, total worldwide debt is approaching $200 trillion. This figure compares to the aggregate notional amount of outstanding OTC derivatives of a minimum of $707 Trillion.
Moreover, comparison of these figures says nothing about who owns what. Many of the owners of the bonds/loans outstanding are not hedged in any way. And many of the owners of the derivatives are naked — making speculative bets and do not own the underlying assets. So, the problem is even worse than it first appears.
That said, the need for a rational constraint on the derivatives market needs to be offset by the need to protect the freedom and flexibility of investors so they can serve their clients’ interests.
Like the Higgs boson discovery, the systemic collapse of the financial markets in 2008 gives us a hint of the destructive power of derivatives. As researchers at CERN gather data, they feel confident that they will soon know whether or not the Higgs boson actually exists. Likewise, many professional investors feel that the escalating debt crisis, particularly in Europe and Japan, will soon demonstrate just how much anti-money derivatives can produce.
Hi Ron,
I’m curious what your stance is on Central Banks is based on this article. It seems to critique and place blame a bit on Central Banks moving to Fiat Currency for our debt, only to be exacerbated by derivatives (please correct me if I’m wrong).
I’m curious though, what are your thoughts on central banks in general, would you prefer to not have them? Is a fiat vs hard money (i.e. gold standard) more stable / are countries better off with one as opposed to the other?
Thanks,
SW
Hi Sean, thanks for the comment. For starters, I need to emphasize that there is no utopian ideal in economic matters – only trade-offs. So, while I favor hard money, I am not suggesting that it does not have its own issues. It does. However, fiat money gives governments and central banks way too much power. Let me give you one example. Interest rates set by the market reflect the ability and willingness of borrowers and lenders to borrow and lend at any point in time. Interest rates set by a central bank reflect what some group of 12 people think the ability and willingness of millions of borrowers and lenders have decided for themselves. It is preposterous. Naturally, the trade-off for arbitrarily setting rates lower than they otherwise might have been is that more people borrow more money than they otherwise would. Central banks are the principle cause of the debt crisis. Because most other governments follow the Fed’s lead, (again, many feel forced to follow as changes in exchange rates affect exports), the Fed’s actions have had global consequences. Moving away from hard money was the first mistake. Keeping rates artificially low at various points in time were major contributors (particularly Greenspan keeping rates low in 2004-2005 time frame). And a long list of government policies outside the Fed’s control (e.g. U.S. trade policy, Fiscal deficits, mandated Affordable Housing/sub-prime goals, etc.) exacerbated the situation.
Very well said.
Hi , I could not understand when you said that in the case of a credit event there would be material impact on the money supply(shrink). For example in case of a credit event in which a cds is triggered, the cds sellers(say a big bank/insurance firm) would have to pay out to the cds buyer, who would again put the money in the bank and therefore it would not have an impact on the money supply. I would be grateful if you could clarify my doubt.
Hi Vinayak. If the credit event were large enough, it would force the system to delever. In your example, assume a specific bank has a large amount of CDS that trigger, say $1 billion. Let’s say the bank has $1 billion in capital. Given the numbers in the article it is impossible to assume that banks will have adequate capital to absorb a large credit event. At some point the banks will not have enough capital. At that point, the bank needs to delever. When the banking system has to delever en masse, it means money supply shrinks. Because we are talking about such LARGE numbers in CDS and other derivatives, this phenomon is likely to create a large credit event. If it were an insurance company that owed on the CDS claim, then they would have to delever creating a ripple effect throughout the economy. In any event, try not to think about it as what happens at one firm, think about what happens when it is many firms at once. Thanks for the question!
Good day,
I feel this attack on derivatives is ill-suited for the CFA publication.
I would like to point out the number that is chronically misused is the Notional Value of Outstanding OTC Derivatives as published by the Bank of International Settlements. The number when taken out of context can give a very skewed picture of reality. It is a well-established empirical fact (possibly also reported by BIS) that that swaps (especially interest rate swaps) take up the largest proportion of all derivative contracts. Swap contracts are always quoted and priced in term of “notional” amounts. For example a very regular swap that a medium size corporation may use, would have a “notional” amount of $100 million. The contract itself would involve swapping a fixed rate of interest (for example 5% per annum) for a floating rate (for example a rate fluctuating between 4.5 % and 5.5% per annum). The actual annual obligation of the swap parties will never exceed $500 000. So when one quotes the Notional Value of Outstanding OTC Derivatives one may get an increase of 200 fold of the true obligation. Obviously large multinationals (and there are at least 500 of them) may be using swaps with notional amounts going into billions of dollars, which together with double counting which is notoriously hard to avoid piles up to a ridiculous amount of $700 trillion. But the amount itself is absolutely devoid of any meaning. It is the same as me saying that I weight 1 million CFAgrams. Until I define CFAgrams it is impossible for anyone to tell whether I am really heavy or not.
Often attacks on derivatives stem from ignorance and are confined to popular press and election speeches; it is thus surprising to see such weak analysis from such a qualified author.
Valeri
Hi Valeri, thank you for your comments, I take your reply constructively. You make a number of valid points in your argument. I don’t disagree. That said, the article is designed to highlight the systemic risk of derivatives in a catastrophic credit event – which is a nontrivial risk in the face of Global Excess Debt – which unfortunately is the state the world today. The important point is that a spike in obligations can lead to collapse of money supply and/or economic activity. I concede that using notional amounts can be misleading, but when trying to tackle the global derivatives market it is a useful standard by which to add up the many and varied derivative instruments. I would also call your attention to the piece of the article that says any constraints need to be offset by preserving the freedom and flexibility of investors so they can pursue their clients’ interests. Derivatives themselves are a good thing. However, the risk of derivatives becoming too large relative to underlying assets is real. Perhaps more precise quantification of that risk can be explored in subsequent pieces. Thanks for your comments and your critique is welcome!
Hi Ron,
I am grateful that you that you agree with my suggestions and I must apologise as I believe my criticism may have been too harsh.
I definitely agree with the notion that derivatives markets left to their own devices may be destabilising and a possible threat to systemic stability. The main reason I feel is counterparty risk because with many complex, over-the-counter instruments institutions often “offset” their risk so many times that at the end one may be very uncertain of the actual identity of the counter party and whether that institution is solvent enough to honour its obligations. A great example of that risk was credit default swaps and AIG who appeared to be the “insurer” in the majority of the transactions. Derivatives are inherently leveraged instruments which further complicates matters and makes the situation potentially explosive.
So naturally I agree with your argument that regulators and financial instructions need to be aware of the pitfalls and thread carefully.
However, as I have mentioned previously, using ridiculous and meaningless (art least in the absolute sense) numbers like $700 trillion (unfortunately the only available measure of the derivative market, I concede) may load the dice in one’s favour and add unnecessary credibility or importance to one’s argument. Regulation of derivatives market is no more important than for example addressing the issues of government and household indebtedness but when one quotes that the derivatives market is as large as $700 trillion it may erroneously appear that other issues fail in comparison.
The notional value of derivatives metric is abused and misused in so many arguments, that I feel it is probably best not to put unnecessary attention on it especially if one’s argument is strong and valid enough without it.
All the best,
Valeri