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Why The Size Of The Derivatives Market Is Cause For Worry

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Apr 18 2007 12:00am EDT

Why the Size of the Derivatives Market is Cause for Worry

Steve Waldman has a really great post on derivatives, which clearly and compellingly sets out the Case for Worry.

The gist is that in a $300 trillion derivatives market, there's bound to be a lot of counterparty risk somewhere. And given how the market is set up, one major counterparty failure could set off a nasty global chain reaction, with serious systemic consequences.

Another way of looking at it: what is that $300 trillion made up of? Let's say that everything is double-counted, and that you can somehow carve it up ito +$150 trillion of positions on one side and -$150 trillion of positions on the other. Then in theory the two add up to zero, and there's no risk. But in the real world, when you take sums as mind-bogglingly enormous as $150 trillion and try to add them up, you'll never be perfectly accurate, and there's likely to be a tiny error in there somewhere. Let's say that tiny error nets out at one tenth of one percent of the total. Well, that tiny error is now a whopping great $300 billion risk.

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