How Risky is the Derivatives Market?

Are you scared by the $300 trillion derivatives market? Jesse Eisinger is. Since his piece in Portfolio came out, Jesse and I have talked about it at some length; he ended up telling me to write a blog entry which he can respond to. Watch this space for Jesse's reply!

So. Is the derivatives market scary? In a word, no. That $300 trillion number – a good five or six times gross world product – is meaningless. It includes untold numbers of contracts which cancelled each other out years ago, and it's based on something called "notional amount" which is vastly larger than the actual sums of money changing hands. An interest-rate swap, for example, might pay out the difference between a fixed rate of 6% and a floating rate of 5%. On a notional $1 million swap, the total payment is just $10,000 per year.

What's more, that payment is probably being used to hedge some other kind of interest-rate risk elsewhere. Most derivatives are not a speculative investment, but are in fact part of an attempt to smooth cashflows and make unpredictable markets more predictable. If you're an airline, for instance, you'd much rather lock in your fuel prices than be subject to the kind of price volaitility that jet fuel has undergone in recent years. And if you're an equities investor, you can use derivatives to protect you from any stock-market crash.

The fact that derivatives are global is a good thing. Jesse quotes the CEO of General Re as saying that "a financial crisis is likely to be a global event, not a local event, and derivatives will probably help make that happen.” To which I say: great! A problem shared is a problem halved.

It's worth remembering, here, that the derivatives market can't crash, in the way that the stock market or bond market can. It's a zero-sum game where for every loser there's a winner. Theoretically, the net amount of wealth tied up in derivatives is zero, which means that no wealth can be destroyed by a market event. In practice, says Jesse, there are some derivatives trades in which both counterparties mark a profit to market. That seems weird to me, but in any case the total amount of wealth at risk is confined to such aberrant valuation procedures within sophisticated financial institutions. If you have money in a pension fund, you're worried about securities markets crashing. You really don't have any worries at all about valuation risk in the derivatives market.

The great thing about derivatives is that short of a major investment bank failing, there's very little systemic risk involved with them. Investors such as Robert Citron or Brian Hunter can and do blow up now and then. But all those concentrated losses simply reflect gains elsewhere in the system. And as for the investment banks, they're subject to exactly the kind of regulations which Jesse claims are needed.

Yes, derivatives are difficult to value, and can end up giving an unwary investor nasty losses. But they perform much more good than harm, in areas from agriculture to catasrophe insurance. The risks are entirely theoretical; the benefits are very real.