Dear SAP Banking Community members.
As you probably know, derivatives are the world’s largest market, dwarfing the size of the bond market and world’s real economy.
The derivatives market is currently at around $600 trillion while the size of the worldwide bond market as of 2009 was approximately $82.2 trillion.
According to the Bank of International Settlements the volume of the Credit Default Swaps is only $36 trillion of these derivatives, and as most of you know, the CDS's had a major responsibility on the Bear Stearns and AIG collapses in 2008. On the other hand, according to the official figures of the International Swaps and Derivatives Association, 80% of the world’s top 500 companies as of April 2003 used interest rate derivatives to control their cash-flows.
These figures become scary if we compare them with the estimated World GDP which is around $58 trillion, and even scarier if we take into account that most of these contracts are Over the Counter with very limited regulatory control (probably you remember that Warren Buffet called them some years ago as “financial weapons of mass destruction”).
Where’s the Danger?
On the last years, in response to very low short-term interest rates, many corporations have swapped their long-term fixed interest rate debt into short-term floating interest rate. Similarly, a growing proportion of homeowners have refinanced their mortgages into adjustable rate structures that are also sensitive to higher short-term yields.
Even more, according theBank for International Settlements, the U.S. interest rate swap market has nearly doubled in size in the past two years, mainly because there are usually several links in the chain from borrower to investor.
“A risky borrower may enter a swap with bank A, which then takes an offsetting swap position with bank B, and so on…”
But this is not the end of the story, as many banks have gone one step further by hedging their investments against the risk of defaults by contracting Credit Default Swaps” with other banks or insurance companies.
In short, the financial system is in a delicate balance:
- On the issuer side, a great many borrowers have linked their debt obligations to short-term interest rates. This mountain of debt in financial system, tied to short-term interest rates, is ultimately and perhaps somewhat inadvertently backed by the governments.
- On the investor side, Asian governments intent on holding their currencies down relative to the U.S. dollar have purchased a great deal of U.S. government debt.
All of which is why the system. is now extremely dependent on short-term interest rates remaining low indefinitely. But, as you can imagine, a reduction of demand for U.S. short-term debt, which forces the government to raise the interest rates, could have very undesirable consequences (don’t forget that the US Government has a huge deficit that must be financed).
Until the third quarter of last year, the banks’ losses in derivatives were almost entirely confined to credit default swaps. But credit default swaps are actually a much smaller sector, representing only 7.8 percent of the total derivatives market.
Thus, considering their far larger volume, any threat to interest rate derivatives could be far more serious than anything we’ve seen so far.
How have can we reached this point and inflated this enormous derivatives bubble? Is there no regulation which could have prevented this?
But the Basel II agreement clearly states the Regulatory Capital that any bank must keep for hedging the risk of its derivative investments. And as the Capital is limited, this should have prevented, or at least limited, the size of the bubble.
What do you think?
Kindest Regards.
Ferran.
As you probably know, derivatives are the world’s largest market, dwarfing the size of the bond market and world’s real economy.
The derivatives market is currently at around $600 trillion while the size of the worldwide bond market as of 2009 was approximately $82.2 trillion.
According to the Bank of International Settlements the volume of the Credit Default Swaps is only $36 trillion of these derivatives, and as most of you know, the CDS's had a major responsibility on the Bear Stearns and AIG collapses in 2008. On the other hand, according to the official figures of the International Swaps and Derivatives Association, 80% of the world’s top 500 companies as of April 2003 used interest rate derivatives to control their cash-flows.
These figures become scary if we compare them with the estimated World GDP which is around $58 trillion, and even scarier if we take into account that most of these contracts are Over the Counter with very limited regulatory control (probably you remember that Warren Buffet called them some years ago as “financial weapons of mass destruction”).
Where’s the Danger?
On the last years, in response to very low short-term interest rates, many corporations have swapped their long-term fixed interest rate debt into short-term floating interest rate. Similarly, a growing proportion of homeowners have refinanced their mortgages into adjustable rate structures that are also sensitive to higher short-term yields.
Even more, according theBank for International Settlements, the U.S. interest rate swap market has nearly doubled in size in the past two years, mainly because there are usually several links in the chain from borrower to investor.
“A risky borrower may enter a swap with bank A, which then takes an offsetting swap position with bank B, and so on…”
But this is not the end of the story, as many banks have gone one step further by hedging their investments against the risk of defaults by contracting Credit Default Swaps” with other banks or insurance companies.
In short, the financial system is in a delicate balance:
- On the issuer side, a great many borrowers have linked their debt obligations to short-term interest rates. This mountain of debt in financial system, tied to short-term interest rates, is ultimately and perhaps somewhat inadvertently backed by the governments.
- On the investor side, Asian governments intent on holding their currencies down relative to the U.S. dollar have purchased a great deal of U.S. government debt.
All of which is why the system. is now extremely dependent on short-term interest rates remaining low indefinitely. But, as you can imagine, a reduction of demand for U.S. short-term debt, which forces the government to raise the interest rates, could have very undesirable consequences (don’t forget that the US Government has a huge deficit that must be financed).
Until the third quarter of last year, the banks’ losses in derivatives were almost entirely confined to credit default swaps. But credit default swaps are actually a much smaller sector, representing only 7.8 percent of the total derivatives market.
Thus, considering their far larger volume, any threat to interest rate derivatives could be far more serious than anything we’ve seen so far.
How have can we reached this point and inflated this enormous derivatives bubble? Is there no regulation which could have prevented this?
But the Basel II agreement clearly states the Regulatory Capital that any bank must keep for hedging the risk of its derivative investments. And as the Capital is limited, this should have prevented, or at least limited, the size of the bubble.
What do you think?
Kindest Regards.
Ferran.
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