As the world financial markets head into complete meltdown, it is worth taking a moment to look back to see where much of this began. A significant portion of the current crisis stems from the shadow banking system’s dependence upon the explosive growth in derivatives market. Put simply, these complex financial instruments are meant to monetize risk of default. Futures contracts, options, swaps, and many others allow one party to insure money is exchanged, but the outcome of the contract depend upon many underlying factors that make up the terms of the contract. Though many forms of derivatives are traded in exchanges, many are not necessarily.
Derivatives that not necessarily traded on market floors are known as “over-the-counter” derivatives. They are usually bilateral contracts between investment banks and a customer and can be generated simply over the phone or over the internet. This form of contracting is largely unregulated. The OTC market has been monitored by the Bank for International Settlements since at 1998, and they publish detailed information on various forms of OTC derivatives every six months. The most recent data can be found here.
This market was very big in 1998, but it has exploded since then. I’ve generated a figure of the amounts outstanding of OTC derivatives since 1998 broken down into their various types.
You should note that the Y-axis is in billions of dollars. Yes, billions. That means, as of Dec 2007 (for which BIS has the most recent data), the total OTC derivative market was almost $600 trillion. With a T. Thus, in 10 years it has gown 826%.
The growth is even more shocking if you look at some of the subcategories of OTC derivatives. Below is a figure illustrating the percentage of amount of outstanding contracts relative to the amount outstanding in June 1998 for interest rate contracts, commodity contracts, and credit default swaps.
Though commodity contracts still make up only a small proportion of the total OTC contracts outstanding (1.5%), its growth has been astronomical, increasing over 2,000% since June of 1998. Even interest rate contracts, which make up the largest portion (66%) of all OTC derivatives, increased over 900% in 10 years. And most troubling of all is the credit default swap market. These are contracts that are activated in the event of a default.
This market has increased 905% in just three and a half years since BIS starting monitoring this form of derivative. It was a mere $6.4 trillion in Dec 2004; In Dec of 2007 this market ballooned to $57.9 trillion. Just think of the unwinding of credit default swaps that is involved when big investment banks like Lehman Bros. go under.
Of course, all of it is very complicated, because derivatives are essentially a “zero-sum” instrument. The way derivatives are supposed to function is that money is exchanged depending on the outcome. Nothing is lost, at least in an ideal environment; it is only exchanged hands. One side wins, the other looses. So it isn’t exactly clear what will happen as these contracts are unwound. But what happens when one party of the contract can’t pay?
I think we’re going to see that many times over very soon…
UPDATE: Be sure to read this excellent piece from the Freakonomics blog explaining the current crisis and the roles of the major players as it stands right now (H/T Bear). They mention that one of the major reasons that AIG was saved was their heavy dependence upon CDSs, $57 billion worth, according to the post. That is exactly 0.1% of the outstanding CDSs according to BIS statistics as of Dec 2007. I’m sure the other 99.9% is perfectly fine…