From June 26th 2012)
Rob Kirkby’s June 2012 blog article, ‘The Greatest Hoax Ever Perpetrated on Mankind’, recently caught my eye:
http://news.goldseek.com/GoldSeek/1339766400.php
It is one of those arcane areas of Finance that really ought to have a little more light shed on it, and probably should be written about much more than it has been. It may be a complex subject and prone to ‘buzzword bingo’ but we ought to persevere. Most people will be out of their comfort zone when exploring the ramifications of derivative trading and I am no exception. However, we should never be afraid to learn or ask questions.
So here goes.
The BIS (Bank of International Settlements) produces a half yearly report of the total number of global derivatives believed to be in existence at the end of a reporting period. The report dated 9th May 2012 had the following comments on ‘key developments in the second half of 2011’:
‘Notwithstanding the increase in the reporting population, total notional amounts outstanding of OTC derivatives declined between end-June and end-December 2011, to $648 trillion. At the same time, gross market values, which measure the cost of replacing existing contracts, increased to $27 trillion, driven mainly by an increase in the market value of interest rate contracts.’
http://www.bis.org/publ/otc_hy1205.htm
So it would appear that we had $648 trillion of derivatives in place at the end of 2011.
Drilling further into the detail we find that of this $648 trillion, the largest element is that of interest rate derivatives, and of those nearly $403 trillion are ‘Interest rate swaps’:
http://www.bis.org/statistics/otcder/dt07.pdf
My feeble and amateur understanding of a credit interest swap is basically that of an exchange of cash flows between two parties. It might be to change a flow based on a fixed rate of interest to a variable rate, perhaps to exploit arbitrage opportunities, or maybe hedge risk in currency based transactions. The purpose and variety of these instruments appears to be almost limitless; each derivative being created pretty much on a bespoke basis to address a specific financial objective.
It stands to reason that as they are ‘binary’ on an individual basis then one of the two parties will be ‘in the money’; one wins, the other loses. Somebody has to take the other side of the trade.
Now this is where I start to have a bit of a problem. Either I need to better understand these things, or something about the whole derivative construct does not add up.
Let’s move on to the banking system, the ‘Big 5’ U.S. banks. I am not comparing ‘like with like’ from a definition perspective in switching from BIS tracking to OCC tracking but that is not really germane to the point I want to make. Limitations and inconsistencies acknowledged, let’s move on.
At the end of March 2012 the total notional amount of derivative contracts for the top five U.S. banks stood at $292.4 trillion:
http://www.occ.treas.gov/topics/capital-markets/financial-markets/trading/derivatives/dq112.pdf
This is an aggregate amount and includes those defined as ‘interest rate swaps’ by the BIS. ‘Swaps’ remain the largest category within the OCC data definition at $168 trillion.
Now this is where my brain starts to seize. The total capital base of these same banks amounts to $8.2 trillion, and this plays an aggregate $292.4 trillion derivative book. Irrespective of whether we are looking at an element of this total or the total itself I cannot believe that the total net exposure between all the banks within the global derivatives market is zero, even less the case for the five largest banks. Are we to believe that the collective banking mind is coincidentally split 50/50 on its global perspective on future interest rates and future FX trading conditions?
The question for me is really one of how much the net exposure of these banks exceeds their aggregate capital base. Is this now the real role of the Exchange Stabilisation Fund, to act as an amelioration element within the global derivatives market?
As implied by Rob Kirby you either believe:
a) That everything eventually nets out to zero.
b) There is an unseen force acting to maintain long term stability.
His ESF argument is starting look plausible.
Far smaller in size but perhaps of more interest to those of us interested in gold and silver is the value of the notional amounts of gold and precious metal contracts at the end of March 2012. According to ‘Graph 8’ this totalled around $153bn for gold and $33bn for other precious metals. However, care is needed in recognising the note: ‘Figures above exclude foreign exchange contracts with an original maturity of 14 days or less, futures contracts, written options, basis swaps, and any other contracts not subject to risk-based capital requirements.’ Refer also to ‘Table 9’ which provides a breakdown by the ‘Big 4’ banks. With $117.4bn in gold and $18.5bn in ‘precious metals’ it will not be a surprise to find that JPM is by far the largest derivatives player in the PM space.
I don’t draw any new conclusions from this other than that it is a confirmation of what we already know: JPM’s PM derivative positions are extraordinarily large and they don’t seem to have any obvious counterparties. Are they supposed to be hedging against themselves, other market derivatives, or is someone else pulling the strings for purposes we can only speculate upon?
The more I learn, the less I seem to understand.