Actually, it is much bigger than half a quadrillion. The OTC market alone is 0.6 quadrillion dollars. The listed derivatives is additive by another $50-60 trillion and makes the aggregate bigger yet.
The below report by the Bank for International Settlements (BIS) is published twice a year on the size, scope and evolution of the derivatives market. Here are a few great takeaways (sometimes direct quotes, sometimes TILB's words, growth rates are all from the mid-year 2008 report):
- "The financial crisis in the second half of 2008 resulted in the first ever decline in the total notional amounts outstanding of over-the-counter (OTC) derivatives since data collection began in 1998. Notional amounts of all types of OTC contracts stood at $592.0 trillion at the end of December 2008, 13.4% lower than their total of $683.7 trillion six months before." These numbers have been reduced to avoid double counting amongst reporting institutions (each contract has two exposures). While that elimination is true from a systemic perspective, you can decide for yourself whether that is appropriate from a micro-perspective.
- "Gross market values, which measure the cost of replacing all existing contracts, represent a better measure of market risk than notional amounts. Despite the drop in amounts outstanding, significant price movements resulted in notably higher gross market values, which increased by 66.5% to $33.9 trillion at the end of December 2008. The higher market values were also reflected in gross credit exposures, which grew 29.7% to $5.0 trillion." Note that US GDP is about $14 trillion.
- As we all know, interest rate derivatives (specifically rate swaps) are by far the largest area of the derivative market. Good news though, notional doesn't matter in rate swaps because, you know, rates never move that much. "In the second half of 2008 the market for OTC interest rate derivatives declined for the first time, after recording an above average rate of growth in the first half of the year. Notional amounts of these instruments fell to $418.7 trillion at the end of December 2008, 8.6% lower than six months before. Despite the decrease in notional amounts outstanding, declining interest rates resulted in a notable 98.9% increase in the gross market value of interest rate derivatives, to $18.4 trillion."
- By the way, imagine what happens if monetarist worries prove out. As TILB talked about in the second half of this post, if the Fed and Treasury truly lose their grip on the value of the dollar, watch out. We're sure this won't cause a trainwreck in derivatives world. Rate derivatives only equal 0.4 quadrillion dollars so the multiplier effect of a huge move in rates would not be against a base of any significant size. Certainly the 0.4 quadrillion dollar market has hedged out its risk elegantly...
- TILB suspects rate derivatives were one of the largest growth areas during the first half of 2009. If our interaction with hedge fund managers is any indication, even equity guys have started hedging rate risk in size. Dealers tell us pensions and insurers, broadly speaking, are on the other side of this macro bet in order to manager their A/L structure.
- Multilateral netting brought down the notional amount of CDS, but gross exposure actually grew by nearly 80%.
- These numbers of course exclude the impact of listed derivatives, which is a much smaller market.
TILB's conclusion: the real "black swan" (we're starting to hate that term for its overuse) lurking out there is the impact of a rate shock on the system. Our suspicion is that the rate derivatives market is not built to handle that shock and that it's size makes the occurance of a shock at some point a virtually certainty.
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