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.

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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.)

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