Opinion

Felix Salmon

A quick note on notional derivatives exposure

By Felix Salmon
September 29, 2009

Vincent Fernando has a blog entry today headlined “It’s Time To Stop Being Scared By Derivatives’ Trillion Dollar Notional Values”. Which is a bit like saying “It’s Time To Stop Being Scared By The $6 Billion Budget Deficit”: both of them are off by a factor of 200 or more.

A decade ago, when notional derivatives exposure started being measured in the trillions, bankers started wheeling out all of Fernando’s arguments in an attempt to reassure the public that there really wasn’t all that much risk here. And if those exposures were still only a trillion or two, I might not be all that worried either. But the likes of Fernando don’t seem to understand that when the notional exposure increases by more than two orders of magnitude, whole new systemic risks can come into play.

US banks made $15 billion trading derivatives in the first half of this year. That’s real money, by anybody’s lights. And nobody believes that you can make $15 billion in the space of six months without running any risk. Indeed, as we’ve learned the hard way, in financial markets the downside tends to dwarf the upside. If US banks can stand to make $15 billion in six months, how much can they stand to lose in the same amount of time? And who would pick up the bill if that happened?

I’m no naif when it comes to deriviatives; indeed, I’ve been on the other side of this argument, explaining how it’s possible for notional exposure to increase without net exposure increasing. But I do get the feeling that far too many people unthinkingly accept that just because such a thing is possible, it must perforce be happening. Even as the revenue figures tell a very different story. (And yes, the credit-exposure figures are falling, but that’s largely a function of the declining notional quantities in the CDS market, which makes up a very small proportion of the total derivatives market.)

Comments
5 comments so far | RSS Comments RSS
 

US banks made $15 billion trading derivatives in the first half of this year.

Thats actually worse. Derivatives, by their nature, are zero-sum instruments. Thats why they are great for financial alchemist-types: their “quantum foam” nature means to create them, you only need to just get two counterparties in the room and poof, they exist.

But you can’t make NET money on such things, just as quantum-foam doesn’t create energy: For every dollar made, another dollar must be lost.

So if banks made $15 billion on derivitives, that means either

a) Some banks didn’t really make this, but have only made this on paper where it will dissapear: if both counterparties show a profit on a derivitive deal, one must be mistaken and will prove to be mistaken in the end.

b) Anything remaining there must be an equal dollar value of losers out there.

Posted by Nicholas Weaver | Report as abusive
 

Stop using naif. You are not writing in French.

Posted by Phil | Report as abusive
 

Nicholas Weaver makes a fine point!

Posted by Dan | Report as abusive
 

I suspect most of the banks’ income from derivatives has been commission or fees on trades between two separate parties, not their profit as a principal in the deal. Do we have any breakdown?

If this is the case, then it’s quite reasonable for the banks to make a profit in return for intermediating a deal between willing buyers and sellers of these derivatives. What’s more, it does not necessarily mean the banks are running any material risks – it is likely to be a simple function of supply and demand. There is very limited supply in the banking sector due to high barriers to entry, so they can charge a high price without taking much risk.

Yes, the high notional derivative figure does indicate the potential for major disruption if things go wrong and a few parties are stuck on the wrong side of a multi-trillion liability (or asset!). But it doesn’t necessarily mean the banks are the ones taking that risk. I suspect the banks are relatively risk-averse right now because they can make decent returns without having to take much risk.

 

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