2007 $516 trillion derivatives market n the context of some other domestic and international monetary data (as of March 2008): U.S. annual gross domestic product is about $15 trillion U.S. money supply is also about $15 trillion Current proposed U.S. federal budget is $3 trillion U.S. government's maximum legal debt is $9 trillion U.S. mutual fund companies manage about $12 trillion World's GDPs for all nations is approximately $50 trillion Unfunded Social Security and Medicare benefits $50 trillion to $65 trillion Total value of the world's real estate is estimated at about $75 trillion Total value of world's stock and bond markets is more than $100 trillion BIS valuation of world's derivatives back in 2002 was about $100 trillion BIS 2007 valuation of the world's derivatives is now a whopping $516 trillion
A security whose price is dependent upon or derived from one or more underlying assets. The derivative itself is merely a contract between two or more parties. Its value is determined by fluctuations in the underlying asset. The most common underlying assets include stocks, bonds, commodities, currencies, interest rates and market indexes. Most derivatives are characterized by high leverage.
A CDS contract involves the transfer of the credit risk of municipal bonds , emerging market bonds, mortgage-backed securities , or corporate debt between two parties. It is similar to insurance because it provides the buyer of the contract, who often owns the underlying credit, with protection against default, a credit rating downgrade, or another negative &quot;credit event.&quot; The seller of the contract assumes the credit risk that the buyer does not wish to shoulder in exchange for a periodic protection fee similar to an insurance premium, and is obligated to pay only if a negative credit event occurs. It is important to note that the CDS contract is not actually tied to a bond, but instead references it. For this reason, the bond involved in the transaction is called the &quot;reference entity.&quot; A contract can reference a single credit, or multiple credits
Mexican financial crisis in 1994, Orange County bankruptcy 1994, and the East Asian financial crisis of 1997 were exacerbated by the use of derivatives to take large positions on the exchange rate. 1995 – Nick Leeson – Baring’s $1.3B loss and bankruptcy 1998 – Long Term Capital Management used derivatives to leverage $2.2 billion in capital into a portfolio with $1.25 trillion at risk, all under the nose of the big banks. 2001 Enron's accountants let it use derivatives to hide at least $3.9 billion in debts. Derivatives transactions allow investors to take a large price position in the market while committing only a small amount of capital – thus the use of their capital is leveraged. Derivatives traded in over-the-counter markets have no margin or collateral requirements, and the industry standard has shown to be deeply flawed by recent failures. Leverage makes it cheaper for hedgers to hedge, but it also makes it cheaper to speculate. Instead of buying $1 million of Treasury bonds or $1 million of stock, an investor can buy futures contracts on $1 million of the bonds or stocks with only a few thousand dollars of capital committed as margin (the capital commitment is even smaller in the over-the-counter derivatives markets). The returns from holding the stocks or bonds will be the same as holding the futures on the stocks or bonds. This allows an investor to earn a much higher rate of return on their capital by taking on a much larger amount of risk. Taking on these greater risks raises the likelihood that an investor, even a major financial institution, suffers large losses. If they suffer large losses, then they are threatened with bankruptcy. If they go bankrupt, then the people, banks and other institutions that invested in them or lent money to them will face losses and in turn might face bankruptcy themselves. This spreading of the losses and failures gives rise to systemic risk , and it is an economy wide problem that is made worse by leverage and leveraging instruments such as derivatives
Eliminate - Exclusions/exceptions for foreign exchange swaps, entities other than swap dealers, and banks exempt under the FDIC Improvement Act of 1991; Add - protection of customer collateral in bankruptcy; and Toughen – Anti-fraud provisions. In addition, we advocate legislation setting aggregate position limits.
Derivatives Briefing 4 Dec09
Derivatives Briefing <ul><li>What are derivatives? </li></ul><ul><li>Are they all bad? </li></ul><ul><li>What is a credit default swap? </li></ul><ul><li>How did derivatives contribute to the economic crisis? </li></ul><ul><li>How can we fix this? </li></ul>
Derivatives - Securities whose price is derived from an underlying asset <ul><li>Types of Derivatives </li></ul><ul><li>Assets to which they can apply: </li></ul><ul><li>Physical Commodities </li></ul><ul><li>Oil, Wheat, Gold, etc. </li></ul><ul><li>Financial Instruments </li></ul><ul><li>Stocks, Bonds </li></ul><ul><li>Foreign Exchange </li></ul><ul><li>Interest Rates </li></ul><ul><li>Regulated by: </li></ul>Put Call swap Future Forward
Derivatives Serve an Economic Purpose <ul><li>Facilitate international trade and investment </li></ul><ul><li>Help utilities and airlines lock in fuel costs </li></ul><ul><li>Help farmers know their selling price at planting time </li></ul><ul><li>Manufacturers can eliminate uncertainty related to input costs </li></ul><ul><li>Price Discovery Auction Market </li></ul>
Exchanges versus Over the Counter (OTC) Derivatives Trades <ul><li>Counterparty Risk </li></ul><ul><li>Price Transparency </li></ul><ul><li>Fairer Pricing, lower broker gouging </li></ul><ul><li>Reduced Volatility </li></ul><ul><li>Fraud Watchdog </li></ul><ul><li>Impede Market Manipulation </li></ul>
Credit Default Swaps & AIG <ul><li>CDS protects the buyer against credit risk in exchange for a fee </li></ul><ul><li>Traded OTC – no supervision! </li></ul><ul><li>1 st trade 1997 </li></ul><ul><li>2007 market=$45 trillion </li></ul><ul><li>AIG Financial Products sold CDS, tripling its revenue to over $3B </li></ul><ul><li>CDS were sold to cover credit risk of bundled subprime loans </li></ul><ul><li>AIGFP lost $25B </li></ul><ul><li>WE put in $134B! </li></ul>
Derivatives in Financial Crisis <ul><li>Fueled housing bubble </li></ul><ul><li>Allowed Wall Street to take on excess leverage </li></ul><ul><li>Exacerbated market decline </li></ul><ul><li>“Too interconnected to fail” firms’ counterparty risk required bailouts </li></ul><ul><li>Systemic risk </li></ul>
Remedies <ul><li>Obama Administration Proposes </li></ul><ul><ul><li>Central Exchange Clearing and Trading of Standardized OTC Derivatives </li></ul></ul><ul><ul><li>Regulation of Derivatives Dealers </li></ul></ul><ul><ul><li>Tools to Combat Fraud & Manipulation </li></ul></ul><ul><li>But this needs to be strengthened by </li></ul><ul><ul><li>Eliminating certain exceptions </li></ul></ul><ul><ul><li>Adding protections of customer collateral </li></ul></ul><ul><ul><li>Toughening Anti-fraud provisions and </li></ul></ul><ul><ul><li>Setting aggregate position limits </li></ul></ul>