March 26, 2013

Size Matters | Naked Capitalism and the $1.2 Quadrillion Question

A blog post over at Naked Capitalism here, alleged the OTC market is now $1.2 Quadrillion in notional value, which was re-posted from another site here, which based its numbers on yet another post here written in June 2010.  One quote below alleges that the trades on the OTC market have a value of $1.2 quadrillion, when of course they mean a notional size, not the same thing.

You read that headline right. By at least one estimate, in 2010 there was a total of $12 trillion in cash tied up (at risk) in derivatives as defined above, all of which controlled contracts connected to assets valued at $1.2 quadrillion.

The article bases this assertion on one of hundreds of repetitions of a quote from Paul Wilmott of Oxford University, all over the Internet – try searching for "1.2 quadrillion and wilmott" and you'll see what I mean. The article then compares the notional value (not actual accounting value) of the OTC market with world GDP – an apples and cheese comparison. The article then makes a giant leap from notional to actual "cash" by taking 1% of that number:

The actual cash amount of the interest rates swaps might be 1% of the $1 million debt, while that $1 million is the “notional” amount. Applying that same 1% to the $1.2 quadrillion derivatives market would leave a cash amount of the derivatives market of $12 trillion — far smaller, but still 20% of the world economy.

No known method of valuing OTC contracts uses the 1% of notional method, something which if true or useful would make OTC derivatives far easier to value. And then in another leap concludes that the seller of a CDS will end up paying out the full notional value of the underlying asset, so therefore justifying that the entire OTC market must in fact be "worth" $1.2 quadrillion.

But with a CDS — a “credit default swap” as discussed here — what’s traded is a fee paid by one side vs. the whole cost of the default paid by the other side. If I as an “insurer” sold a hedge fund a CDS on $20 million in GM bonds, and those bonds default, I’m on the hook for the whole $20 million, the “notional” value. As a result, I accept the $1.2 quadrillion notional value number. But I think the $12 trillion cash-at-risk number is way low. And “just” $12 trillion is, as they point out, still 20% of world GDP. Stunning.

It's an amazing chain of logic which has no basis in fact, most CDS contracts don't pay out, and if they do, it's on the amount of loss which is often well above the 100% loss the author alleges, wikipedia has a list of credit events here: Finally the article points out that the $1.2 quadrillion is from 2010 and according to the author the banks have got 'fatter' since so we must all be doomed. Stats from ISDA show the total size of the OTC market has in fact reduced, partly due to the efforts of TriOptima to tear up contracts and remove trades. Some data The Bank for International Settlements (BIS) in Switzerland measures the size of the OTC market regularly, you can see a graph in this report: which shows the total size hovering around the $600trn mark (interesting that this half the alleged $1.2 quadrillion) – perhaps someone decided to assume the BIS is only counting one side of each trade, the original data is here: The latest PDF shows that at mid 2012 there was outstanding contracts of $638trn with a gross market value of $25trn, actually bigger than the 1% method above. Some more data ISDA addressed this very narrative in a comprehensive post explaining how to step from notional value, to market value, and by including posted collateral arrive at the amount of exposure outstanding.

From Notional to Value The ISDA analysis removes double counting caused by cleared trades, removes FX trades added by the BIS which don't really fall into the OTC camp, and then adds in collateral posted to cover exposure. Their figures in summary:

  • $440trn total OTC market size
  • Gross Market Value $27trn, meaning before the netting of exposure between parties, which is absolutely fundamental to the ISDA Master Agreement and bankruptcy treatment
  • Netted credit exposure of $3.9trn
  • Around 70% of this is covered by posted collateral
  • Leaving a total credit exposure of $1.1trn

In simple terms the exposure outstanding is 0.2% of the notional value of the trades in the market. Different from the $12trn arrived at by the 1% method above, and follows a trail of logic that relates back to the legal basis for the market, and treatment in a bankruptcy court. Compared to the Bonds, Loans and Equity Markets My colleague Jon Skinner did a recent post on this same topic, and surprisingly the OTC market is a lower amount of value outstanding than that of Bonds, Equities and Loans, you can see his analysis here: Jon makes the point that this comparing current exposure and not any potential future exposure, which in some proportion is covered by margin postings at CCPs, especially for the IRS trades. What's the point? The Notional size of an OTC trade is indirectly related to the market value of an OTC contract, yet as the process for pricing an OTC trade involves an explanation of yield curves and/or the Black Scholes option model, public commentators resort to what they most easily quote. The time is ripe to move on from trying to scare people by using large numbers, and apply some research before producing articles such as the one at Naked Capitalism. Contact from Paul Wilmott I made contact with the source of the $1.2 quadrillion quote and he had this to say:

It was from the BIS website late 2008. Or rather there were lots of numbers for different types of contract and they summed to that 1.2. Tim Harford the FT and BBC Radio 4 economist and I talked about this on his "More or Less" radio programme.

R4 More Or Less:

On January 23 2009, Paul Wilmott returned to explain how the value of the global derivatives market could possibly be three times that of the world economy – a figure amounting to $150 trillion. [near the bottom]

AHHH – I found it – listen to the 4 minute audio clip at the bottom, the $1.2 quadrillion is a sum of OTC AND Exchange Traded Derivatives NOTIONALS. Hence the meme started with people all over the world using that number as the value and therefore predicting financial doom.

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