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Explaining $605 Trillion of Derivatives

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The Bond Vigilantes are dead -- long live the Sultans of Swap.

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Editor's Note: Long is a former senior group executive with IBM & Motorola, a principle in a high tech public start-up and founder of a private venture capital fund. He is presently involved in private equity placements internationally along with proprietary trading involving the development & application of Chaos Theory and Mandelbrot Generator algorithms. Read more of his content on Sultans of Swap.


Every parent has had that moment when their child asks them the simplest sounding question but in that instance before you respond, you realize you have never really thought about it and actually don't know the real truth. To not have an answer would be to lose all credibility as the "all-knowing" parent. Like generations of parents before you -- you bluff!

When asked why there are $605 trillion derivatives outstanding (source: June 2009 Semiannual OTC derivatives statistics at end-June 2009 BIS) how do you articulate an answer to this horrendous and almost unimaginable number? The US is the largest economy in the world but tallies only 2.3% in comparison. Global bank reserves amount to only 1.2% of this accumulation. The gargantuan size appears to defy all logic.

Before some of you experts out there accuse me of sensationalism, let me quickly give you the response of the "all-knowing" to knock this number down to something that's intended to allow you to once again sleep at night.

First $605 is the notional value. This number according to experts (source: 10-15-08 $596 Trillion! How can the derivatives market be worth more than the world's total financial assets? Slate) is best used simply to get an indication of how rapidly the overall derivatives market is growing (wow) since it doesn't represent the value of what's at stake to the parties engaged in the transaction. It double counts positions, doesn't represent what changes hands, and doesn't discount hedges that offset each other. What we need to consider is settlement amounts if all the contracts had to be settled today for some unknown reason (i.e. a 1930s bank holiday crisis?). Our number then drops to just over $25 trillion. That sounds better but still is a staggering figure considering the assets of the US are estimated to be $56 trillion, and is one-third of global assets (source: Jan 2008 McKinsey & Company -- Mapping Global Capital Markets: Fourth Annual Report -- Executive Summary -- January 2008). Not to be deterred our "all-knowing" experts would then assuredly point out that actually the number is a mere $3.7 trillion when all the contracts directly offsetting each other are netted. Appeased, our cocktail chatter would resume in a much more subdued tone. Or should it?

I've been thinking about the truth regarding this imponderable for a few years now. I have likewise successfully answered the question at numerous polite social gatherings but never felt comfortable with my response. My credibility intact I'd scold myself to delve more thoroughly.

Eureka!

While authoring my recent article "8 Fault Lines in the Euro Experiment" which was prompted by the debacle in Greece, I found myself like Archimedes the Greek before me, shouting Eureka -- I have alas found it! But before I share the "all-knowing truth" with you, I must caution those with weak hearts and small children: Parental guidance is advised!
No positions in stocks mentioned.

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