Posts Tagged 'graph'

Credit crunch: Derivatives market explained in simple(ish) terms

Former FT journo Tom Foremski seems to quote liberally from other people’s blogs. I think on Twitter, this would be called a Re-Tweet…

The Size of Derivatives Bubble = $190K Per Person on Planet

By Tom Foremski – October 16, 2008

More must read financial analysis from DK Matai, Chairman of the ACTA Open.

The Invisible One Quadrillion Dollar Equation — Asymmetric Leverage and Systemic RiskAccording to various distinguished sources including the Bank for International Settlements (BIS) in Basel, Switzerland — the central bankers’ bank — the amount of outstanding derivatives worldwide as of December 2007 crossed USD 1.144 Quadrillion, ie, USD 1,144 Trillion. The main categories of the USD 1.144 Quadrillion derivatives market were the following:

1. Listed credit derivatives stood at USD 548 trillion;

2. The Over-The-Counter (OTC) derivatives stood in notional or face value at USD 596 trillion and included:

a. Interest Rate Derivatives at about USD 393+ trillion;

b. Credit Default Swaps at about USD 58+ trillion;

c. Foreign Exchange Derivatives at about USD 56+ trillion;

d. Commodity Derivatives at about USD 9 trillion;

e. Equity Linked Derivatives at about USD 8.5 trillion; and

f. Unallocated Derivatives at about USD 71+ trillion.

Quadrillion? That is a number only super computing engineers and astronomers used to use, not economists and bankers! For example, the North star is “just” a couple of quadrillion miles away, ie, a few thousand trillion miles. The new “Roadrunner” supercomputer built by IBM for the US Department of Energy’s Los Alamos National Laboratory has achieved a peak performance of 1.026 Peta Flop per second — becoming the first supercomputer ever to reach this milestone. One Quadrillion Floating Point Operations (Flops) per second is 1 Peta Flop/s, ie, 1,000 Trillion Flops per second. It is estimated that all the data found on all the websites and stored on computers across the world totals more than One Exa byte of memory, ie, 1,000 Quadrillion bytes of data.

Whilst outstanding derivatives are notional amounts until they are crystallised, actual exposure is measured by the net credit equivalent. This is normally a lower figure unless many variables plot a locus in the wrong direction simultaneously. This could be because of catastrophic unpredictable events, ie, “Black Swans”, such as cascades of bankruptcies and nationalisations, when the net exposure can balloon and become considerably larger or indeed because some extremely dislocating geo-political or geo-physical events take place simultaneously. Also, the notional value becomes real value when either counterparty to the OTC derivative goes bankrupt. This means that no large OTC derivative house can be allowed to go broke without falling into the arms of another. Whatever funds within reason are required to rescue failing international investment banks, deposit banks and financial entities ought to be provided on a case by case basis. This is the asymmetric nature of derivatives and here lies the potential for systemic risk to the global economic system and financial markets if nothing is done.

Let us think about the invisible USD 1.144 quadrillion equation with black swan variables — ie, 1,144 trillion dollars in terms of outstanding derivatives, global Gross Domestic Product (GDP), real estate, world stock and bond markets coupled with unknown unknowns or “Black Swans”. What would be the relative positioning of USD 1.144 quadrillion for outstanding derivatives, ie, what is their scale:

1. The entire GDP of the US is about USD 14 trillion.

2. The entire US money supply is also about USD 15 trillion.

3. The GDP of the entire world is USD 50 trillion. USD 1,144 trillion is 22 times the GDP of the whole world.

4. The real estate of the entire world is valued at about USD 75 trillion.

5. The world stock and bond markets are valued at about USD 100 trillion.

6. The big banks alone own about USD 140 trillion in derivatives.

7. Bear Stearns had USD 13+ trillion in derivatives and went bankrupt in March. Freddie Mac, Fannie Mae, Lehman Brothers and AIG have all ‘collapsed’ because of complex securities and derivatives exposures in September.

8. The population of the whole planet is about 6 billion people. So the derivatives market alone represents about USD 190,000 per person on the planet.

The Impact of Derivatives

1. Derivatives are securities whose value depends on the underlying value of other basic securities and associated risks. Derivatives have exploded in use over the past two decades. We cannot even properly define many classes of derivatives because they are highly complex instruments and come in many shapes, sizes, colours and flavours and display different characteristics under different market conditions.

2. Derivatives are unregulated, not traded on any public exchange, without universal standards, dealt with by private agreement, not transparent, have no open bid/ask market, are unguaranteed, have no central clearing house, and are just not really tangible.

3. Derivatives include such well known instruments as futures and options which are actively traded on numerous exchanges as well as numerous over-the-counter instruments such as interest rate swaps, forward contracts in foreign exchange and interest rates, and various commodity and equity instruments.

4. Everyone from the large financial institutions, governments, corporations, mutual and pension funds, to hedge funds, and large and small speculators, uses derivatives. However, they have never existed in history with the overarching, exorbitant scale that they now do.

5. Derivatives are unravelling at a fast rate with the start of the “Great Unwind” of the global credit markets which began in July 2007 and particularly after the collapse of Freddie Mac and Fannie Mae in September this year.

6. When derivatives unravel significantly the entire world economy would be at peril, given the relatively smaller scale of the world economy by comparison.

7. The derivatives market collapse could make the housing and stock market collapses look incidental.

Three Historical Examples

1. The so-called rogue trader Nick Leeson who made a huge derivatives bet on the direction of the Japanese Nikkei index brought on the collapse of Barings Bank in 1995.

2. The collapse of Long Term Capital Management (LTCM), a hedge fund that had a former derivatives and bond dealer from Salomon Brothers and two Nobel Prize winners in Economics as principals, collapsed because of huge leveraged bets in currencies and bonds in 1998.

3. Finally, a lot of the problems of Enron in 2000 were brought on by leveraged derivatives and using derivatives to hide problems on the balance sheet.

The Pitfall

The single conceptual pitfall at the basis of the disorderly growth of the global derivatives market is the postulate of hedging and netting, which lies at the basis of each model and of the whole regulatory environment hyper structure. Perfect hedges and perfect netting require functioning markets. When one or more markets become dysfunctional, the whole deck of cards could collapse swiftly. To hope, as US Treasury Secretary Mr Henry Paulson does, that an accounting ruse such as transferring liabilities, however priced, from a private to a public agent will restore the functionality of markets implies a drastic jump in logic. Markets function only when:

1. There is a price level at which demand meets supply; and more importantly when

2. Both sides believe in each other’s capacity to deliver.

Satisfying criterion 1. without satisfying criterion 2. which is essentially about trust, gets one nowhere in the long term, although in the short term, the markets may demonstrate momentary relief and euphoria.


In the context of the USD 700 billion rescue plan — still being finalised in Washington, DC — the following is worth considering step by step. Decision makers are rightly concerned about alleviating immediate pressure points in the global financial system, such as, the mortgage crisis, decline in consumer spending and the looming loss of confidence in financial institutions. However, whilst these problems are grave, they are acting as a catalyst to another more massive challenge which may have to be tackled across many nation states simultaneously. As money flows slow down sharply, confidence levels would decline across the globe, and trust would be broken asymmetrically, ie, the time taken to repair it would be much longer. Unless there is government action in concert, this could ignite a chain-reaction which would swiftly purge trillions and trillions of dollars in over-leveraged risky bets. Within the context of over-leverage, the biggest problem of all is to do with “Derivatives”, of which CDSs are a minor subset. Warren Buffett has said the derivatives neutron bomb has the potential to destroy the entire world economy, and is a “disaster waiting to happen.” He has also referred to derivatives as Weapons of Mass Destruction (WMD). Counting one dollar per second, it would take 32 million years to count to one Quadrillion. The numbers we are dealing with are absolutely astronomical and from the realms of super computing we have stepped into global economics. There is a sense of no sustainability and lack of longevity in the “Invisible One Quadrillion Dollar Equation” of the derivatives market especially with attendant Black Swan variables causing multiple implosions amongst financial institutions and counterparties! The only way out, albeit painful, is via discretionary case-by-case government intervention on an unprecedented scale. Securing the savings and assets of ordinary citizens ought to be the number one concern in directing such policy.


To reflect further on this, please respond within Facebook’s ATCA Open discussion board.

We welcome your thoughts, observations and views. Thank you.

Best wishes

DK Matai

Chairman, ATCA Open

— ATCA, The Philanthropia, mi2g, HQR —

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Recession graph – shape: canoe – property still falling

I was talking to a North American this week. Some of the updates are all over my Twitter feed. While there’s generally optimism in my blog posts, I’m trying a persona of gloom on Twitter.

The average price of a house sale in Detroit in Jan/Feb? Well, according to her, $8000. That’s a pretty interesting number because it shows the depth of the sub-prime woes and just how much oversupply there is for housing in places that are dependent on industries that are in trouble. The motor manufacturing sector hasn’t yet died, but it’s getting a discounting from the local population!

While Sir Martin Sorrell famously suggested the bust recovery graph would track the shape of a bath, Canadians talk about a canoe shape. My friend reckons it’ll be a canoe!

Fire Canoe #2 by peter bowers

My previous discussions have pondered whether the graph shape will actually an ‘L’ with a long horizontal or a ‘W’ with a fake bounce in the middle or a ‘wonky W’ that bounces a bit but doesn’t end ahead or a ‘lightning strike’ with plateaux areas of comfort that are followed by slides.

The important thing to note, oh graph watchers, is the issue of microscope views. When you look through a microscope, even a straight line has jagged edges. So, as we ponder the recessionary descent, the graph is certainly not going to be a smooth freefall.

If there is general agreement that it’s still a fall… does it matter if there are plateaux? Yes, if you get fooled into thinking that a plateau is the bottom and you are in a hurry to buy back in to take the bounce – and it turns into a further slide.

My sense, with unemployment on the rise, with the banks still locked, with companies feeling further pinches, is that property prices are still on the slide. That they will continue to slide as the lag effect of unemployment euphoria makes way for reality to bite – that it’s a long old slog for many to get back into a job that will pay the same as a pre-crunch set-up.

Recalibration of the whole economy is still going on. The quantitative easing of the UK government may soften some of the effects, but we’re still coming back to earth on the slide. And, whether it’s a plateau or a floor… the bounce isn’t going to be strong or sustained or rapid.

The waiting game continues on a broad sweep of business activity. The vultures are not hungry enough to fly. And, the phoenix can sleep for a good few years in his egg that’s resting on the ashes… but the phoenix is taking strength from the heat to rise again.

Phoenix by BenGoode

Recession – songs

My credit crunch themes of ornithology and graphs and animals… now theme tunes too. Try these lyrics for Friday afternoon:

Magic Pennywords and music by Malvina Reynolds; copyright 1955 and 1958.
Love is something if you give it away,
Give it away, give it away.
Love is something if you give it away,
You end up having more.

It’s just like a magic penny,
Hold it tight and you won’t have any. 
Lend it, spend it, and you’ll have so many
They’ll roll all over the floor.

For love is something if you give it away,
Give it away, give it away.
Love is something if you give it away, 
You end up having more.

Money’s dandy and we like to use it,1
But love is better if you don’t refuse it.
It’s a treasure and you’ll never lose it
Unless you lock up your door.

For love is something if you give it away,
Give it away, give it away.
Love is something if you give it away,
You end up having more.

So let’s go dancing till the break of day,
And if there’s a piper, we can pay. 
For love is something if you give it away,
You end up having more.

For love is something if you give it away,
Give it away, give it away.
Love is something if you give it away,
You end up having more.

Recession graph – shape – who’s for the ski jump?

Ski-jump in Kuopio by camera-caritatis


I’m not alone in musing about the recession, timings and upturn. My musings have taken the form of wondering about the shape of the graph – will it be an L? a W? a Wonky W?

I was discussing this last night with the CTO of Venda, an online e-commerce platform and a guy with podcast business who’s badge I misread as SmallBusinessPoo.

My point is – it depends what day of the week as to what you think the recession is going to do. On a Fridays, I find I’m more wont to think it’ll be a V… which demonstrates the day when there’s more confidence and devil may care. 

It also depends who you talk to. The personal recession graph may be totally different, because one’s own career or business may be counter-cyclical or a beneficiary of the displacement effect of changed spending patterns. So, caravan holidays are doing a hockey stick… small down, big up.

And, start-ups that have no ‘down’ can see just a straight line up… wait for that bell-curve, guys… for today is all about growth, not plateaux.

So, should we care when the telegraph reports:

“Nothing moves down in straight lines,” said SocGen’s perma-bear Albert Edwards. “There will be little bounces. But our view is that investors can afford to be lazy and wait. There is not a cat’s chance in hell that this really is the bottom of the cycle.” (Full article about green shoots of economy –

You know what. Don’t. A nicely bullish restauranteur told me yesterday… we don’t have any competition but ourselves. We stick to what we know. We work hard. We do our thing, respond to our specific situations. You can look too hard at following others – it all gets bitchy and pathetic. Just do your own thing. Inner confidence and gritty drive. That’s something to salute.

So far as others go… and the change in spending patterns… there was a side-swipe that the 300-cover Oxo Tower Restaurant had 15 diners in at lunchtime on Wednesday. Ouch.

For some people, that graph might just resemble a ski jump. And, ski jumps are for the very brave.

Charlie’s Twitter status

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