How big is $600 Trillion? Scary big.

The derivatives market is complex and largely fairy-tale finance. The vast supra-majority of people (presidents, presidential candidates, and Congress included) do not understand the derivatives market, and most barely even know the market exists. If you are unfamiliar with derivatives, please refer to my first post yesterday, which attempts to explain derivatives in layman's terms (and I am a layperson, I have not even traded in puts and calls on stocks).

The derivatives market has a face value of $600 Trillion. While the entire $600 Trillion is not at risk (see "What the heck is a derivative"), I have an enormous problem with the notional value of the derivatives market. The world's GDP is $65 Trillion - outstanding derivatives have a face value ~10 x the entire World's annual income. Warren Buffet is the world's wealthiest person, with a net worth of $62 Billion - about 1/10,000th. In fact, the net worth of the 25 wealthiest people, worldwide, combined, is just over $750 Billion - about 1/1,000th of the face value of the derivatives market. The net worth figures do not necessarily reflect the 30%+ decline in the stock market. The world's 100 richest people have a combined net worth of about $1.7 Trillion.

The 25 wealthiest people's net worth represents the value of everything they own - derivatives, real estate, stocks, bonds, businesses, precious metals, everything. Generally, the wealthiest 1% of people own about 1/3rd of all financial assets. The world's 100 richest people have a combined net worth of about $1.7 Trillion. The derivatives market has a notional value of about $600 Trillion.

There are approximately 1,000 Billionaires in the world - the "poorest" person out of the 100 richest was George Soros, with an estimated net worth of $9 Billion. If we assume that the other 900 Billionaires have an average net worth of $5 Billion, their combined net worth is about $4.5 Trillion. The derivatives market has a notional value of about $600 Trillion.

The world's population is about 7 Billion people. The derivatives market has a notional value of about $600 Trillion. That is about $100,000 for every man, woman, and child in every city, village, prison, slum, and palace in the world.

There are about 10 Million millionaires. From Market Watch: "The high-net-worth population swelled 6% last year to more than 10.1 million people who own assets totaling an eye-popping $40.7 trillion, according to the CapGemini/Merrill Lynch World Wealth Report." The derivatives market has a notional value of about $600 Trillion.

From Slate: "By contrast, the value of the world's financial assets—including all stock, bonds, and bank deposits—was pegged at $167 trillion last year by McKinsey. "

Most financial assets are held long-term. $167 Trillion in net worth of financial assets does not equal anywhere near $167 Trillion in transactions. And derivatives are a very narrow slice of markets. The relatively enormous size of the derivatives market in comparison to the world's assets is enervating.

Okay, but it's not $600 Trillion at risk. First off, we can assume that about half of the derivatives contracts are, say, betting that the market will go up, while the other half are betting that the market will go down. The market can only go up or down, so assume that roughly half of the derivatives bets cancel each other out. Furthermore, derivatives contracts tend to be time sensitive, so many will expire without paying out a dime. The purchase price is the dollar amount that actually trades hands when a contract is created - the purchase prices are a relatively sane $17 Trillion or so. But going back to my insurance policy analogy - if you pay $800 to buy a one-year homeowner's insurance policy worth $100k, only $800 changes hands until something happens to the house. Then, the insurance company could pay out up to $100k. So the money in play in derivatives is somewhere between the $17 Trillion purchase price and the $600 Trillion notional value.

Worse, the other side of the derivative trade may not have any money at all to back up his promises.

Remember, a stock option contract is a type of derivative. If I bought a put contract for $2 that guarantees me the right to sell Intel stock at $20 a share, I would be exercising that contract now that Intel is down around $14. The person who sold me the contract - the counter party - would be out $4 (the $20 face value minus the $2 contract minus the $14 share price today). The loss, in that case, would be twice the contract purchase price and 1/5th of the notional value. If I had been trading in financial stocks, the loss could be nearly the entire notional value; even Exxon is down 29%.

One of the early links in this post is to an article that says that only about $3 Trillion dollars is actually at risk, because most derivatives contracts will cancel each other out. I take issue with that claim - prove it. Because most traders are rational. If I bet you $5 that the sky is blue, would you find someone else to bet $5, with the same odds, that the sky is not blue? Probably not. Even if you found someone willing to bet that the sky is not blue, because they want to hedge a bet they made with me that the sky is blue, you wouldn't give them the same terms - you would charge a lot more to make a bet you are likely to lose, and you would charge very little to make a bet you're certain you'll win. But then a storm comes along, the sky turns purple, and you're out your lunch money because you never thought you'd lose that bet.

As financial markets go crazy, a lot more contracts are paying out than usual. Because there are essentially no reserve requirements for derivatives issuers, this is somewhat akin to Hurricanes Katrina, Andrew, and Iniki all hitting at the same time as major Midwestern flooding, tornadoes throughout the Southeast, and earthquakes up and down the West coast. The "insurance" companies can't pay out on massive and unexpected losses - they are designed to pay out on reasonably expected losses. You can reasonably expect 1 Cat 5 hurricane in a year; 2 would be bad but not shocking, three would probably bankrupt some insurance companies. I'll take any bet if I'm certain I won't pay out - and I bet a lot of Wall Street types, especially the ones betting with someone else's money, felt the same way. Only a very few people expected the Dow to drop from 14,000 to 8,400. Few people expected oil to rise to $140, and fewer still expected it to rise to $140 and then fall to $64. Unprecedented circumstances give rise to unprecedented profits and losses, and it's easy to be on the wrong side of a bet.

"3. Unregulated, over-the-counter derivatives. There are scary numbers floated
out there (in the hundreds of trillions of dollars or more) of “notional value” outstanding. The problem with these numbers is that they don’t represent
actual amount-at-risk, and in fact nobody seems to know what that figure actually is. The lack of a regulated exchange and central clearing means that there is no margin supervision of any sort; ergo, you have no way to know if your contract is in fact good (that is, the other guy has the money.) AIG, as an example, had $500 billion dollars of exposure outstanding in these contracts, and while this sounds somewhat reasonable when one considers they have a $1 trillion dollar balance sheet in fact
it is not because most of AIG’s balance sheet assets are committed to cover liabilities
(e.g. insurance policies, annuities and the like.) The lack of margin and regulatory supervision is directly responsible for this. These derivatives have become nothing more than a fancy game of “pick pocket”, where Broker “A” sells protection to Client “A” for $X, and then tries to find someone to buy that same protection from for “$X – something.” While speculation in the marketplace is fine, speculation without being able to prove capital adequacy to back up your bets is not." ... from http://www.denninger.net/letters/paulson-bernanke-senate.pdf

Bottom line: Who can afford a $17 Trillion loss? How about $4 Trillion? $50 Trillion? In a global economy where the value of everything produced and sold in the entire world is just $65 Trillion a year, I don't think anyone can afford to back $600 Trillion bets, even if the losses are mere tens of Trillions.

Notes: Trade in derivatives data comes from the Bureau of International Settlements. $600 Trillion is rounded. World GDP is likely understated somewhat, because there is no official tracking of grey market, black market, contraband, and under-the-table income. All figures in U.S. dollars are subject to exchange rate fluctuations.