While people focus on Greece, Spain and if Facebook is a bubble, the derivatives market is still exploding. Here are some thoughts by mainly Wilmott on notional value, derivatives, regulation and crashes. Via Daily Finance.
One of the biggest risks to the world’s financial health is the $1.2 quadrillion derivatives market. It’s complex, it’s unregulated, and it ought to be of concern to world leaders that its notional value is 20 times the size of the world economy. But traders rule the roost — and as much as risk managers and regulators might want to limit that risk, they lack the power or knowledge to do so.
A quadrillion is a big number: 1,000 times a trillion. Yet according to one of the world’s leading derivatives experts, Paul Wilmott, who holds a doctorate in applied mathematics from Oxford University (and whose speaking voice sounds eerily like John Lennon’s), $1.2 quadrillion is the so-called notional value of the worldwide derivatives market. To put that in perspective, the world’s annual gross domestic product is between $50 trillion and $60 trillion.
To understand the concept of “notional value,” it’s useful to have an example. Let’s say you borrow $1 million to buy an apartment and the interest rate on that loan gets reset every six months. Meanwhile, you turn around and rent that apartment out at a monthly fixed rate. If all your expenses including interest are less than the rent, you make money. But if the interest and expenses get bigger than the rent, you lose.
JPMorgan Chase & Co. Chief Executive Officer Jamie Dimon said the firm suffered a $2 billion trading loss after an “egregious” failure in a unit managing risks, jeopardizing Wall Street banks’ efforts to loosen a federal ban on bets with their own money.
Good luck closing those positions out, especially when all competitors know your positions. This is a big blow to all OTC dealing, and a huge boost to the Volcker rule. Expect the OTC business to slowly dry up going forward. Video below.
Derivatives have a long-standing history as financial instruments for managing financial risks stemming from changes in macroeconomic conditions. They thus represent important risk management tools for companies, authorities and financial institutions as they can be used to manage exposure to interest rate, currency, commodity price or other risks. Globally, the OTC derivatives market volume amounts to USD 600 trillion; nearly 85% of the world’s out- standing derivatives market volume is accounted for by OTC derivatives.
Derivatives range from fully standardised to tailor-made products: fully standardised derivatives are usually traded on exchanges, whereas customised contracts are traded over-the-counter (OTC). Thus, as OTC derivatives markets are generally characterised by flexible and tailor-made products, satisfying the demand for bespoke contracts customised to the specific risks that a user wants to hedge, OTC derivatives often comprise privately negotiated contracts, with only the participants having access to detailed information. In contrast, exchange-traded derivatives, which are by definition standardised contracts, leave a transparent trail in terms of positions, prices and scale of exposures while OTC derivatives markets have historically been largely unregulated with respect to the disclosure of information even though operations in these markets were executed by supervised entities. As a result, information available to market participants and supervisors has long been limited.1