The derivatives piece is totally wrong of course. Gross Notional is a completely meaningless number - it does not represent what value is owed or how much risk there is.
E.g GS could have 1tr of gross notional of derivatives with JP but with zero risk or monies owed if the positions all offset (as indeed in real life they do, banks run very little net exposure).
But of course newspapers and grotty rags like to perpetuate this narrative that derivatives are going to blow up the world.
Well, to be fair, derivatives almost did blow up the world in 2008. Definitely overestimated in terms of impact, but really something we should have a better handle on.
Over-enthusiastic mortgage lending to poor borrowers without risk, because the risk was wisely managed and diversified through perfectly designed, financial, innovative products that covered all the bases (for a nice commission, of course).
The mortgages everything was based on were junk, because they were guaranteed by the GSEs that couldn't handle the rate and size of the defaults on junk mortgages.
That is one part of it. Those mortgages could be blended into derivatives, which could then be run up in a speculative bubble. Pretending there was a single cause for the financial crisis is a little disingenuous on both our parts.
what does "blended into derivatives" mean? Yes mortgages were sold on a packaged up into MBS (Mortgage back securities), but these are cash products, like a bond or equity, NOT a derivative.
> What would they be called if they aren't derivatives?
Securitised bonds, which is a cash product.
The distinction between a cash & derivative product is really simple - one is leveraged the other isn't. E.g if I buy 100m of MBS I actually have to cough up 100m in cash - I am buying both the interest and principal repayments of the underlying mortgages.
On the other hand if I enter into an interest rate swap with 100m notional I don't pay anything at all (assuming traded at spot market levels, and ignoring initial margin). The risk, or sensitivity, to interest rates is the same on both, but am only paying out cash for the securitised bond.
Hence the bond, or MBS is "cash" and the swap is "derivative".
Ahh. I stand corrected. Looking at your later post (which for some reason I can't respond to directly): so the derivatives are just what amplified the MBS crash with leverage -- allowed organizations to put more money into toxic MBS assets than they would normally be able to with cash? All the splitting and recombining of MBS does that not act as a vehicle for laundering or coverup? I mean it wasn't technically laundering because it was completely legal to offer mortgages to people who couldn't afford them. But didn't the MBS allow banks to resell those poor assets which normally wouldn't have been sought after as investments? And the investments were leveraged through derivatives so that crashing of the poor quality assets were amplified? So it seems that there was a complex interaction of unregulated financial vehicles that caused the crisis and not simply "bad mortgages" or simply "derivatives" or simply "MBS". Any one of those alone would not have caused a huge bubble and crash, right? I do not have a background in finance, but I think it is important for a layperson to understand what happened.
Derivatives did exacerbate the unwinding of the mortgage mess, because the chain of title was so convoluted. I've read reports of people who were given homes in south Florida because the owners of mortgage debt were unable to finish foreclosure proceedings before the statute of limitations ran out. That is an extreme case, but the milder case of banks being landlords when that's not what they're good at, plus borrowers being stuck in foreclosure limbo longer than should be necessary, introduces unnecessary friction in the economy that wastes time and money.
This could be the self-regulating limit for derivatives - the legal time required to unwind them in the case of mass redemptions, bounded by the business cycle length and statute of limitations for a locality.
Weren't the banks selling each other credit default swaps they couldn't cover, such that the moment a single bank went under it triggered the collapse of the entire banking system? Blaming the mortgage lending is like saying, "I didn't blow up the neighborhood with my unsupervised warehouse full of explosives, it was those damn kids playing with matches!"
I understand how positions can offset and cancel each other out. What I don't understand is if the notional value is never fully redeemed, why use leverage at all? That is, if only the spot prices are used to actually exchange money, why inflate the value of a trade with leverage?
I apologize if I'm misusing terms - I'm not a finance expert.
The only explanation I can think of is that leverage is used to exploit dumb money that isn't hedged correctly. In which case, leverage is a barrier to entry that diminishes the number of participants in a market and reinforces cartel behavior. Which I would think is a bad thing.
Well, leverage is kind of a separate is from whether or not your entering into a derivative contract or making an investment in the underlying asset. Bu the simple answer is, the more you lever up any investment, the more money you stand to make.
The notional is purely a reference amount. For the vast majority of derivatives the notional amount is never exchanged (cross-currency basis swaps being a notable exception).
E.g a simple interest rate swap: I agree to pay you 2% per annum on a reference notional of 100m for 10 years, and in exchange you pay me libor referencing the same notional. At the end of first year let's say libor fixes at 1.98%. Hence I pay you a net 0.02% (2% - 1.98%) of 100m, i.e 20,000. We do this every year for 10 years.
It is just a way to hedge interest rate exposure - e.g I have borrowed 100m paying a Libor-linked interest rate and don't want to run the risk that Libor spikes to 10% or whatever.
There's nothing complicated about this, at least in principle. Derivatives just allow people to hedge out exposures they don't want.
I see. So if you pay cash now you are vulnerable to interest rate swings. Whereas if you use leverage to spread the term of your investment out, you can average the interest rate across the business cycle and achieve more predictable behavior. Is that correct?
Consider that borrowing 10 year money at the 6-month LIBOR rate is equivalent to borrowing at LIBOR for 6 months and rolling the debt 19 times.
The swap market provides a linkage between the money market ( borrowing < 1 year) and the capital market (borrowing > 1 year), and allows one to borrow (or lend) where the comparative advantage is better.
The 10 year swap rate is then a market number which represents the relative demand (and supply) within the money & capital markets.
I'll note that the article doesn't have a giant box for the combined value of all insurance policies, maybe because it's obvious that having $100,000 liability policy for your car insurance doesn't sound technical and scary like "derivative."
What blows my mind is that it seems like everyone in the media has taken this obviously incorrect premise and run with it.
The problem with derivatives is that they are functionally very similar or identical to insurance. But, because they are sold under a different name, the capital requirements for selling insurance do not apply. Insurance is less scary for a reason. Higher capital requirements, and less concentration of risk, means that insurance can't blow up the world economy.
Well, not quite -- if odds of winning are in fact around 1 in 200MM or less, there is no market failure here.
Their point would still stand if they sold 100MM tickets though, so as not to confuse the two issues (ie. the notional amount and the expected value), perhaps it would have been a better example that way.
In a one-off lottery scheme, the jackpot of a lottery should be less than or equal to the value of all of the contributions.
Did you introduce a central bank into the example some point? Is this a repeated game? Am I missing something? If not, this reddit comment makes no sense whatsoever.
This is not what's happening though AFAIK. In the lottery illustration there will be a single payout. In derivatives the risk of default for a certain "class" is treated as IID, and banks can leverage a certain amount on different risk classes (100x is not unusual).
But as 2007 demonstrated the real world risk is not IID. And at 100x leverage a 1% movement can totally wipe out a bank.
Also it's not like the 2007 crisis was fixed in any meaningful way. The FED just bought 1.4 trillion of MBS derivatives and is now sitting on them, actual value still unclear. Probably to be paid by the tax payer through 20 years of austerity.
But this has nothing to do with notional value. The world wouldn't be safer if we rewrote all contracts saying "1% on a notional amount of $100M" with "1M% on a notional amount of $100".
If this was true, Lehman Brothers would still be in operation today. Derivatives, by their very nature, are harder to truly evaluate in terms of value, and the chance of them going horribly wrong has already been demonstrated as being non-zero (see GFC).
Lehman went bust because liquidity in the credit markets dried up - i.e they were unable to roll short-term financing to fund longer-dated balance sheet. The markets thought Lehman had big exposure to the US residential and commercial mortgages, hence they couldn't borrow, hence they went bust.
A shame because they weren't actually bankrupt - PWC has now recovered 100% of liabilities with assets to spare.
How long did the recovery take? PWC recovered those assets now, rather than then. In the mean time there was a huge reflation of the stock and housing markets, powered by the Federal Reserve in the short term and a return of confidence in the medium term.
You can't treat mass psychology as an externality. Austerian policies rely in part on disciplining debtors to restore confidence in market transparency and the rule of law. If thousands of households lost their homes when their cash flow could not meet their debt payments, why shouldn't a bank go bankrupt when its cash flow cannot meet its debt payments? Lehman was just the bank that couldn't find a seat when the music stopped, and that's fair.
Yes, but that has nothing to do with the notional value of derivatives or derivatives "blowing up." They had a liquidity crisis because of fear; people stopped trusting their commercial paper and were skeptical of lending to them with repos backed by difficult-to-value mortgage-backed securities.
"The markets thought Lehman had big exposure to the US residential and commercial mortgages, hence they couldn't borrow, hence they went bust."
This is the sort of thing I mean when I say derivatives are hard to evaluate correctly. So yeah, Lehmans totally went bust because of their large amounts of trading in CDS.
This is exactly right. People are confusing risk with notional. There's no risk adjustment anywhere, but clearly the values need to be adjusted for how much they might change.
The cash will be (by construction) the same tomorrow, but the shares could easily vary by a few percent.
I agree with this, but let's not forget about the counterparty risk making the interconnected financial system so fragile. If GS offsets its [long position with JP] with a [short position with Citi], and Citi goes under, GS is screwed.
yeah but most interbank dealing is collaterised now so little counterparty credit risk left (altho this does arguably just shift counterparty risk to funding risk, but that's another story...)
Comparisons of gross national to other measures of value or risk aside, isn't the point that the risks inherent in this magnitude of derivatives trading are simply not understood? "Blowing up the world" might be hyperbole. On the other hand, these markets are mostly unregulated. Does anyone really understand the systemic risk posed by this segment of the market?
In a more ELI5 sense, would it be true to say that derivatives are not "real money" in the same sense that company valuations are not?
Company valuations are projections created through some combination of extrapolation of growth or value and (often in the earlier stages) just agreeing on a number to make the percentages and such work out correctly. They are expressed as a dollar amount but those are not real dollars.
"But of course newspapers and grotty rags like to perpetuate this narrative that derivatives are going to blow up the world."
It's no secret that Warren Buffet is strongly against these derivative products and considers them to be one of the most dangerous financial products in history.
So why is he "perpetuating the narrative" as you dismissively claim?
I want to bring him up because you're hiding behind attacking the newspaper and "rags", so let's instead point to one of the most successful investors in modern history who agrees.
Why is he wrong? Please don't hide behind dismissal and attacks, as a man of Warren Buffets caliber has proven through real world demonstration that he possess a vast understanding of these markets and products.
Something as simple as a swap is a derivative. Swaps are common and no doubt some of Warren Buffet's businesses use FX swaps to avoid being exposed to currency fluctuations.
What would be intensely interesting would be if that derivatives number was broken down by type of derivative. That would be something worth discussing.
Normally you're right that no net exposure implies no risk. However, you've completely forgotten the financial crisis? Counterparty risk can completely destroy the idea of "all positions are offset". If I buy a derivative and then re-sell it for a profit, that's fine until the people I bought it from suddenly go under, and now my position is not protected anymore!
Read this critique on Reddit this morning. Thought it was interesting.
Sharing here:
"Ah, this misleading derivatives stuff again...
In two steps:
Firstly, I'll use as an example something called an interest rate swap. If you have a loan with floating rate interest payments, then this lets you change that to a fixed interest rate of say 4%. As follows:
The lender requires you to pay floating rate interest. The swap is an agreement with a third party derivatives guy that you should receive a floating rate from him and pay fixed to him. So every month you will receive whatever the floating rate is from the derivatives guy, and pay a fixed rate to him - and the floating you receive pass on to the guy charging interest on the loan.
For example: the loan has a floating rate payment which at the moment is 4%, and you agree with the derivatives guy that you should pay him a fixed rate of 4% and will receive whatever the floating rate is. If the floating rate rises to 8%, then you pay the derivatives guy 4% and receive 8% and pass those 8% on to the lender. If the floating rate falls to 2%, you pay the derivatives guy 4% and receive 2% and pass those on to the lender.
But 4% of what? For the calculation to work, you need a monetary amount to calculate 4% of. That is the notional. You receive cash of the floating rate * the notional, and pay cash 4% * the notional. You need some way to translate the percent into actual cash payments and that happens through the notional.
If your loan is 10m, then the notional amount you want is probably 10m. If you only want half fixed half floating, then you can set the notional amount to 5m.
But the notional amount is just the basis used for calculation. It's not "money". It's a figure plugged into a formula. The notional isn't put into the bank and can't be withdrawn from it, and at the end of the period of interest payments the notional isn't there anymore because its only purpose was to calculate those interest payments.
If someone wanted to they could break that entire counting system by simply making a swap with a notional of 1 centillion dollars and deciding the payment isi equal to 5% * notional / 1 centillion. If you wanted to swap 100m USD you would need 100m of these contracts for a notional of 100 million centillion dollars. The actual money changing hands is nowhere near the notional.
Secondly:
Sometimes people use derivatives for speculation. What they can do is enter a contract and then after prices change they enter the opposite contract.
For example: contracts for oil 6 months from now are $50 per barrel. Someone buys contracts for 50 million barrels. Then the price changes to $60 per barrel. He then sells contracts for 50 million barrels.
The only practical effect of this trade is that he receives a cash sum today. In 6 months nothing happens - they are automatically matched and offset.
In this case the notional amount would be the price of 50 million barrels of oil times 2.
Now, it's possible to do this at high speed. So rather than wait until the next day, he enters a contract and then the opposite seconds or milliseconds from each other. As long as the buying and the selling is for the same amount, this could make for an arbitrarily high notional.
There are absolutely risks in derivatives. For example, what happens if one party loses enough money to go bankrupt and all the bonds they placed as security for that event isn't enough to cover the loss. But the notional amount is not a good place to start to understand risks. Like, every type of derivative will have its own rules for how the notional translates into actual cash - e.g. for an oil contract it would be the full value of the oil, and for an interest rape swap it would just be the amount that's multiplied by the percentage.
Not someone who works with this daily, but covered it quite well in studies."
Debt can be considered money, but not all kinds of derivatives, especially swaps. Debt usually has some kind of collateral: physical, business cash flow etc. Insurance will have direct interest, an actuarial basis and reserves. Swaps may have neither of these. A metaphor is a blackjack table. The players place real money bets. The house/dealer pays on known statistics. Swaps are like bystanders betting on the players and hands they see and expecting the house to pay off.
It doesn't sound like there is any leverage in this explanation? Isn't that part of the purpose of derivatives -- for leverage? If you are buying and selling faster than the transactions can be closed is that where the leverage comes in? So some multiple or percent of the transaction should be counted as more than the buy/sell price?
Debt is backed by assets, which were undercounted by this graphic. I'd be very interested to see the estimated value of residential real estate compared to the derivatives market.
Yes but if I get a mortgage, the amount of debt issued is equal to the amount of money I get by taking on that debt. The fact that the debt is secured by the real estate doesn't change that.
Not only is there more debt than money, but even if the world turned over all of its coins, banknotes, gold, commercial real estate, publicly traded companies, and bank accounts to its creditors, it would still come up short by $33 trillion.
There must be a lot of assets that aren't accounted for by this chart.
Considering that the nominal value of above-ground gold reserves is comparable to that of commercial real estate worldwide, it looks overvalue to me.
There is so much productive use of commercial real estate, while gold is at best a medium of exchange and quite an inconvenient one relative to coins and banknotes. (Gold's industrial value is much lower than this and arguably its psychic value would not hold up well without its liquidity as money.)
I imagined for whatever reason that if one would account the 'global economy' as a closed system then debt + value would come at a balance. Didn't consider derivates as holding such a huge value. That also mean most of the debt is backed by gambling with production yield, which is scary.
Should the world ever value the global stock of Bitcoin similarly to gold, Bitcoin's market capitalization would increase by around 1,300 times, from ~$6 billion to ~$7.8 trillion, and the price per Bitcoin would increase from around $460/BTC to around $600,000/BTC, give or take.
If this sounds "crazy," consider that in many ways, Bitcoin is more convenient than physical gold: it's cheaper to secure, transport, and hide; and unlike gold, it's backup-able.
--
On a related note, here are some additional thoughts on Bitcoin I wrote four years ago, when its price was $9/BTC:
Bitcoin is, however, unlike gold, not a physically limited resource, which is what makes gold a more functional trading goods.
The entire concept of economy relies on the belief that an item without value can be used to represent value. Which is only accomplished through the belief of rarity.
Bitcoin does have a mechanism to mirror this though. The rate of discovery halves every 4 years and only 21 million will ever be issued.
When the blockchain was started 50 Bitcoins per block were awarded until november 2012 when it was halved to 25. It is predicted to half again in 2017.
Bitcoin is just as rare as gold (in fact, rarer). Mining only happens at a certain rate (you can't just materialize Bitcoins out of thin air) and it is capped at 21 million total.
You do know where gold comes from, right? From real, physical mines. It's not like you can materialize it out of thin air either (well, strictly speaking, you can, but it's not feasible currently) and there's a limited supply; however much is in the earth.
Uh, yes I know that. My core point is that Bitcoin and gold are equally rare, not that gold is somehow not rare.
Bitcoin might be considered "rarer" to the extent that the rate is pretty much fixed. It's not trivial to double the overall mining rate, whereas gold mines could substantially ratchet up production if they wanted to. (If a gold miner increases his mining rate, it doesn't affect the rate of other miners. But if a bitcoin miner suddenly brings a lot more computing capacity online, it's going to decrease the mining rate of other miners.)
Bitcoin allows 210 trillion units. 21MM bitcoins times 10MM Satoshis. If Bitcoin was the only currency, then a Satoshi would be somewheres around a dollar in the current global economy.
The probably with a bounded currency is that it doesnt match economic growth. Economic growth is the product of innovation times productivity and population growth.
It is not unconceivible that in a hundred years there may be a million CPUs/bots toiling per person in a fully expressed Internet of Things. (The current USA level is thought to be about 200 per human including cars, household appliances and cloud databases.) Either the per capita wealth is going to be vastly more than now or a bounded currency highly revalued.
The number of bitcoin units is just a property of the number of decimal places that are used in each transaction. Bitcoin can actually be changed to support more in the future if needed.
This has no economic effects since you're just adding more ways to subdivide a dollar.
If you're looking for weaknesses, there's a list here:
Currencies have two functions: mean of payment and storing value.
A currency like bitcoin can only be the second one in an effective way, that's what I think he meant.
And that's a big problem cause we really don't particularly need a better way to store value, but something that makes commerce more effective from a structural point of view not just a technological one.
Those certificates are issued by third parties who must secure, transport, and hide the physical gold.
Those third parties spend quite a bit to store the gold in secure facilities guarded around the clock, transport the gold from/to those facilities in armored vehicles, and keep the gold hidden from view, e.g., in underground vaults.
Guess who ends up paying fees to cover all those costs?
Divide the number of bitcoin transactions by the power spent mining, and each transaction consumes enough power to run an American household for a day and a half.
The biggest flaw with that calculation is that most Bitcoin miners are not located in American households.
They're naturally located where electricity is much cheaper: they're using environmentally-generated or surplus power, close to the source, at bulk industrial rates. The author even said it in the same article, but did not factor it into the clickbaiting comparison.
I think you should probably research that a little better. If you see look on wiki[1] you can see a focus on gold held by governments. The US for instance holds 8000 tons of gold.
However if you dig ;-) deeper you find out that a country like India is estimated to have 15,000+ tons [2] of gold held privately traditionally as jewelry. This Indian form of savings is widespread and does contradict your statement regarding physical gold. Other countries have similar although normally less savings held in this form.
But should the world ever value the global stock of Bitcoin similarly to gold? I see no reason to suppose that it should. Why should you pick gold out of the list of options, instead of, say, stocks? Or silver? (In fact, silver is much closer to where it is at the moment.)
Secure/hide: It has the same attack surface as gold, plus the downsides of potentially being exposed to online attacks, along with shoddy wallet implementations fail to use sufficient entropy in address generation, fail to only send to valid and current addresses, etc. I don't hear about people having their gold stolen or otherwise losing it on a daily basis, but I do hear about people losing their bitcoins all the time.
Transport: an obvious advantage of bitcoin and it is currently cheaper, yet with the uncertainty in the blocksize debate and the utter lack of transparency in fee calculation, this may not always be the case. Transport currently simply fails sometimes on a miner's whim, and the user is left waiting for the transaction to clear from the mempool of enough nodes that they can respend the coins.
There is currently no reason to believe that bitcoin per se can scale to even silver sizes from that graph, let alone come anywhere close to gold.
Secure/hide: I disagree. A lot of gold is stored in heavily guarded, hidden underground vaults, which have evolved to be secure over thousands of years. I can't imagine why or how securing and hiding Bitcoin could ever be costlier than that.
Yeah, you can encrypt Bitcoin and so secure it with a passphrase, which can be memorized and all hard copies thrown away. Then you can distribute the files in hundreds of places, and not have to secure them.
I'd be hard-pressed to imagine a scheme more secure than that. If the crypto fails, Bitcoin is going to be worthless anyway.
He'd have to know it's a Bitcoin wallet first, then he'd have to know it's yours.
With a vault, he could just point his gun at you and demand you get your people on the line to withdraw it and give it to him.
Your comment has me doing a threat model in my head, and you're right it's not perfect, but I still can't imagine a better scheme. Essentially, if an adversary can break through your personal security and is capable and willing to threaten your life, then you have much bigger problems than losing your stash.
Why do you think that you can't lock bitcoins in a vault? You just put your private key on a disk or flash drive or print it as a QR code and then lock that in a vault. It's called a cold wallet. That's what huge holders of bitcoin do to mitigate the risk of a security breach. They keep a small working amount of bitcoin in a hot wallet and keep the rest safe offline.
Basically, you can memorize multiple passphrases, each of which leads to a valid set of addresses. If you're under duress, you can provide the passphrase to a dummy wallet that doesn't contain your full balance. As far as the attacker is concerned, they have no idea that a second account even exists.
I think this ignores the very real risk of simply forgetting the passphrase. It's not really an apples to apples comparison, but I do think there are significant, and in many cases similar, advantages and drawbacks to both.
Gold gets stolen all the time. Most people only keep it in the form of jewelry, but almost everyone knows several people who've had someone break into their house and steal it. (People who keep gold as a stash of wealth generally don't have it in their physical possession.) I'd argue there are probably thousands of instances of gold theft for every one of bitcoin.
It's just not much of a story. Bitcoin is new and interesting, gold isn't.
You're comparing a currency + transaction network with a commodity. IMO, as long as people treat Bitcoin as a commodity it will not achieve its true purpose.
I like xkcd's visualization better, because the quantities are displayed logarithmically: each part of xkcd's visualization uses squares which represent 1000 times more money than the previous part's squares.
I immediately though about this XKCD post. Does they mention it in the article? Not going to say it's a ripoff, but I can't imagine that the didn't get inspired by it.
My experience is that big tech company jobs are much better than at the typical startup.
I got my first job working for one of the big 3 tech companies a couple of years ago after a long string of startups that failed or fizzled going back to the dot-com days. I always felt like I was making reasonable-to-good base salary at startups with the potential to hit it big with stock options.
Starting my job as a regular IC at big tech company was immediately an eye opener. Out of the gate my base salary was 10% higher than I made as a manager at my most recent startup. With bonus and publicly traded stock value after a year, I was making ~50% more and stock becoming even more valuable over time.
My first startup was great as I went in at 25 with no college and only self taught tech skills. In hindsight, this was a great (probably only) way to start but pivoting to big tech would have been a better move instead of trying to strike it rich at a startup.
Nice chart, although it would be really important to see references to the data sources and more notes on methodology (at the very least, they should have included dates on which the valuations were measured! Also, how exactly do we define "debt" and how is it computed/where is it referenced from?)
Also, the "Rest of the World" stock market capitalization is much larger than I would have expected, since it seems to exclude the largest exchanges (US+Europe+China+Japan). It would be nice to see a more detailed breakdown of that; perhaps I should do one :)
I would guess India+Brazil should be pretty large combined, and there are probably companies with tiny & illiquid float trading on obscure exchanges, but large capitalizations.
And yes, as another commenter noted, using the notional for derivatives valuation is really quite misleading -- I guess this is the easiest number to compute, and is probably the one supporting the point they are trying to make, but there should at least be more of a note telling people about it.
Still, nice work! It's good to see things in perspective.
When I scrolled down and saw that derivatives were so large by an order of magnitude I was reminded of this awesome 2010 Oscar winning documentary that I only watched a couple of weeks ago:
It's about how US executives created the financial crisis back in 2008 and is pretty relevant here. I'd well recommend watching it...some of the information provided is uniquely depressing and terrifying.
123 comments
[ 2.7 ms ] story [ 178 ms ] threadE.g GS could have 1tr of gross notional of derivatives with JP but with zero risk or monies owed if the positions all offset (as indeed in real life they do, banks run very little net exposure).
But of course newspapers and grotty rags like to perpetuate this narrative that derivatives are going to blow up the world.
https://en.wikipedia.org/wiki/Derivative_%28finance%29#Mortg...
Everything based on junk mortgages were junk.
What would they be called if they aren't derivatives?
Securitised bonds, which is a cash product.
The distinction between a cash & derivative product is really simple - one is leveraged the other isn't. E.g if I buy 100m of MBS I actually have to cough up 100m in cash - I am buying both the interest and principal repayments of the underlying mortgages.
On the other hand if I enter into an interest rate swap with 100m notional I don't pay anything at all (assuming traded at spot market levels, and ignoring initial margin). The risk, or sensitivity, to interest rates is the same on both, but am only paying out cash for the securitised bond.
Hence the bond, or MBS is "cash" and the swap is "derivative".
This could be the self-regulating limit for derivatives - the legal time required to unwind them in the case of mass redemptions, bounded by the business cycle length and statute of limitations for a locality.
I apologize if I'm misusing terms - I'm not a finance expert.
The only explanation I can think of is that leverage is used to exploit dumb money that isn't hedged correctly. In which case, leverage is a barrier to entry that diminishes the number of participants in a market and reinforces cartel behavior. Which I would think is a bad thing.
E.g a simple interest rate swap: I agree to pay you 2% per annum on a reference notional of 100m for 10 years, and in exchange you pay me libor referencing the same notional. At the end of first year let's say libor fixes at 1.98%. Hence I pay you a net 0.02% (2% - 1.98%) of 100m, i.e 20,000. We do this every year for 10 years.
It is just a way to hedge interest rate exposure - e.g I have borrowed 100m paying a Libor-linked interest rate and don't want to run the risk that Libor spikes to 10% or whatever.
There's nothing complicated about this, at least in principle. Derivatives just allow people to hedge out exposures they don't want.
The idea of the interest rate swap is simply that some entities prefer to lock in a rate, others prefer to have it float. So they swap those risks.
The swap market provides a linkage between the money market ( borrowing < 1 year) and the capital market (borrowing > 1 year), and allows one to borrow (or lend) where the comparative advantage is better.
The 10 year swap rate is then a market number which represents the relative demand (and supply) within the money & capital markets.
"If Powerball sells 1 million tickets at 2$ each, where the jackpot is worth 200,000,000$, is the size of that market 2M$ or 200 trillion $" [1]
[1] https://www.reddit.com/r/Economics/comments/3xb2xh/all_of_th...
What blows my mind is that it seems like everyone in the media has taken this obviously incorrect premise and run with it.
Their point would still stand if they sold 100MM tickets though, so as not to confuse the two issues (ie. the notional amount and the expected value), perhaps it would have been a better example that way.
Did you introduce a central bank into the example some point? Is this a repeated game? Am I missing something? If not, this reddit comment makes no sense whatsoever.
But as 2007 demonstrated the real world risk is not IID. And at 100x leverage a 1% movement can totally wipe out a bank.
Also it's not like the 2007 crisis was fixed in any meaningful way. The FED just bought 1.4 trillion of MBS derivatives and is now sitting on them, actual value still unclear. Probably to be paid by the tax payer through 20 years of austerity.
A shame because they weren't actually bankrupt - PWC has now recovered 100% of liabilities with assets to spare.
You can't treat mass psychology as an externality. Austerian policies rely in part on disciplining debtors to restore confidence in market transparency and the rule of law. If thousands of households lost their homes when their cash flow could not meet their debt payments, why shouldn't a bank go bankrupt when its cash flow cannot meet its debt payments? Lehman was just the bank that couldn't find a seat when the music stopped, and that's fair.
This is the sort of thing I mean when I say derivatives are hard to evaluate correctly. So yeah, Lehmans totally went bust because of their large amounts of trading in CDS.
The cash will be (by construction) the same tomorrow, but the shares could easily vary by a few percent.
Company valuations are projections created through some combination of extrapolation of growth or value and (often in the earlier stages) just agreeing on a number to make the percentages and such work out correctly. They are expressed as a dollar amount but those are not real dollars.
specifically this book: http://www.amazon.com/s/ref=nb_sb_noss?url=search-alias%3Dst...
It's no secret that Warren Buffet is strongly against these derivative products and considers them to be one of the most dangerous financial products in history.
So why is he "perpetuating the narrative" as you dismissively claim?
I want to bring him up because you're hiding behind attacking the newspaper and "rags", so let's instead point to one of the most successful investors in modern history who agrees.
Why is he wrong? Please don't hide behind dismissal and attacks, as a man of Warren Buffets caliber has proven through real world demonstration that he possess a vast understanding of these markets and products.
What would be intensely interesting would be if that derivatives number was broken down by type of derivative. That would be something worth discussing.
Sharing here:
"Ah, this misleading derivatives stuff again... In two steps: Firstly, I'll use as an example something called an interest rate swap. If you have a loan with floating rate interest payments, then this lets you change that to a fixed interest rate of say 4%. As follows:
The lender requires you to pay floating rate interest. The swap is an agreement with a third party derivatives guy that you should receive a floating rate from him and pay fixed to him. So every month you will receive whatever the floating rate is from the derivatives guy, and pay a fixed rate to him - and the floating you receive pass on to the guy charging interest on the loan. For example: the loan has a floating rate payment which at the moment is 4%, and you agree with the derivatives guy that you should pay him a fixed rate of 4% and will receive whatever the floating rate is. If the floating rate rises to 8%, then you pay the derivatives guy 4% and receive 8% and pass those 8% on to the lender. If the floating rate falls to 2%, you pay the derivatives guy 4% and receive 2% and pass those on to the lender.
But 4% of what? For the calculation to work, you need a monetary amount to calculate 4% of. That is the notional. You receive cash of the floating rate * the notional, and pay cash 4% * the notional. You need some way to translate the percent into actual cash payments and that happens through the notional.
If your loan is 10m, then the notional amount you want is probably 10m. If you only want half fixed half floating, then you can set the notional amount to 5m. But the notional amount is just the basis used for calculation. It's not "money". It's a figure plugged into a formula. The notional isn't put into the bank and can't be withdrawn from it, and at the end of the period of interest payments the notional isn't there anymore because its only purpose was to calculate those interest payments.
If someone wanted to they could break that entire counting system by simply making a swap with a notional of 1 centillion dollars and deciding the payment isi equal to 5% * notional / 1 centillion. If you wanted to swap 100m USD you would need 100m of these contracts for a notional of 100 million centillion dollars. The actual money changing hands is nowhere near the notional.
Secondly: Sometimes people use derivatives for speculation. What they can do is enter a contract and then after prices change they enter the opposite contract. For example: contracts for oil 6 months from now are $50 per barrel. Someone buys contracts for 50 million barrels. Then the price changes to $60 per barrel. He then sells contracts for 50 million barrels.
The only practical effect of this trade is that he receives a cash sum today. In 6 months nothing happens - they are automatically matched and offset. In this case the notional amount would be the price of 50 million barrels of oil times 2.
Now, it's possible to do this at high speed. So rather than wait until the next day, he enters a contract and then the opposite seconds or milliseconds from each other. As long as the buying and the selling is for the same amount, this could make for an arbitrarily high notional.
There are absolutely risks in derivatives. For example, what happens if one party loses enough money to go bankrupt and all the bonds they placed as security for that event isn't enough to cover the loss. But the notional amount is not a good place to start to understand risks. Like, every type of derivative will have its own rules for how the notional translates into actual cash - e.g. for an oil contract it would be the full value of the oil, and for an interest rape swap it would just be the amount that's multiplied by the percentage.
Not someone who works with this daily, but covered it quite well in studies."
Also, all the debt is a liability for the debtor but an asset for the creditor. We could just change the label in the graph.
Of course it does:
https://research.stlouisfed.org/fred2/series/M1SL
There must be a lot of assets that aren't accounted for by this chart.
There is so much productive use of commercial real estate, while gold is at best a medium of exchange and quite an inconvenient one relative to coins and banknotes. (Gold's industrial value is much lower than this and arguably its psychic value would not hold up well without its liquidity as money.)
Is his fortune largely tied to Microsoft's share price?
(he was buffett's bridge partner.)
Should the world ever value the global stock of Bitcoin similarly to gold, Bitcoin's market capitalization would increase by around 1,300 times, from ~$6 billion to ~$7.8 trillion, and the price per Bitcoin would increase from around $460/BTC to around $600,000/BTC, give or take.
If this sounds "crazy," consider that in many ways, Bitcoin is more convenient than physical gold: it's cheaper to secure, transport, and hide; and unlike gold, it's backup-able.
--
On a related note, here are some additional thoughts on Bitcoin I wrote four years ago, when its price was $9/BTC:
https://cs702.wordpress.com/2011/05/29/on-the-potential-adop...
The entire concept of economy relies on the belief that an item without value can be used to represent value. Which is only accomplished through the belief of rarity.
When the blockchain was started 50 Bitcoins per block were awarded until november 2012 when it was halved to 25. It is predicted to half again in 2017.
https://en.bitcoin.it/w/index.php?title=Controlled_supply&re...
Bitcoin might be considered "rarer" to the extent that the rate is pretty much fixed. It's not trivial to double the overall mining rate, whereas gold mines could substantially ratchet up production if they wanted to. (If a gold miner increases his mining rate, it doesn't affect the rate of other miners. But if a bitcoin miner suddenly brings a lot more computing capacity online, it's going to decrease the mining rate of other miners.)
The probably with a bounded currency is that it doesnt match economic growth. Economic growth is the product of innovation times productivity and population growth. It is not unconceivible that in a hundred years there may be a million CPUs/bots toiling per person in a fully expressed Internet of Things. (The current USA level is thought to be about 200 per human including cars, household appliances and cloud databases.) Either the per capita wealth is going to be vastly more than now or a bounded currency highly revalued.
This has no economic effects since you're just adding more ways to subdivide a dollar.
If you're looking for weaknesses, there's a list here:
https://en.bitcoin.it/wiki/Weaknesses
Deflation is more of an economic problem then subdivision; since it's very unlikely that can be changed.
Bitcoin does not operate on a debt model and is not susceptible to the kind of deflation that the most widely used currencies are.
Those third parties spend quite a bit to store the gold in secure facilities guarded around the clock, transport the gold from/to those facilities in armored vehicles, and keep the gold hidden from view, e.g., in underground vaults.
Guess who ends up paying fees to cover all those costs?
Certificate holders.
A lot of someones burn a lot of electricity 24x7 in order for bitcoin to hold any value, too - and bitcoin holders pay for it just the same.
http://motherboard.vice.com/read/bitcoin-is-unsustainable
They're naturally located where electricity is much cheaper: they're using environmentally-generated or surplus power, close to the source, at bulk industrial rates. The author even said it in the same article, but did not factor it into the clickbaiting comparison.
However if you dig ;-) deeper you find out that a country like India is estimated to have 15,000+ tons [2] of gold held privately traditionally as jewelry. This Indian form of savings is widespread and does contradict your statement regarding physical gold. Other countries have similar although normally less savings held in this form.
[1] - https://en.wikipedia.org/wiki/Gold_reserve [2] - http://blogs.wsj.com/indiarealtime/2011/07/14/indias-600-bil...
Secure/hide: It has the same attack surface as gold, plus the downsides of potentially being exposed to online attacks, along with shoddy wallet implementations fail to use sufficient entropy in address generation, fail to only send to valid and current addresses, etc. I don't hear about people having their gold stolen or otherwise losing it on a daily basis, but I do hear about people losing their bitcoins all the time.
Transport: an obvious advantage of bitcoin and it is currently cheaper, yet with the uncertainty in the blocksize debate and the utter lack of transparency in fee calculation, this may not always be the case. Transport currently simply fails sometimes on a miner's whim, and the user is left waiting for the transaction to clear from the mempool of enough nodes that they can respend the coins.
There is currently no reason to believe that bitcoin per se can scale to even silver sizes from that graph, let alone come anywhere close to gold.
Reasons to believe why Bitcoin might scale to gold sizes from that graph over time: my thoughts on this are at https://cs702.wordpress.com/2011/05/29/on-the-potential-adop...
I'd be hard-pressed to imagine a scheme more secure than that. If the crypto fails, Bitcoin is going to be worthless anyway.
I think vaults probably handle that scenario better.
With a vault, he could just point his gun at you and demand you get your people on the line to withdraw it and give it to him.
Your comment has me doing a threat model in my head, and you're right it's not perfect, but I still can't imagine a better scheme. Essentially, if an adversary can break through your personal security and is capable and willing to threaten your life, then you have much bigger problems than losing your stash.
Basically, you can memorize multiple passphrases, each of which leads to a valid set of addresses. If you're under duress, you can provide the passphrase to a dummy wallet that doesn't contain your full balance. As far as the attacker is concerned, they have no idea that a second account even exists.
It's just not much of a story. Bitcoin is new and interesting, gold isn't.
https://xkcd.com/980/
Edit: I wonder if it has something to do with the fact that silver (unlike gold) is consumed in manufacturing processes such as photography.
https://xkcd.com/980/
I got my first job working for one of the big 3 tech companies a couple of years ago after a long string of startups that failed or fizzled going back to the dot-com days. I always felt like I was making reasonable-to-good base salary at startups with the potential to hit it big with stock options.
Starting my job as a regular IC at big tech company was immediately an eye opener. Out of the gate my base salary was 10% higher than I made as a manager at my most recent startup. With bonus and publicly traded stock value after a year, I was making ~50% more and stock becoming even more valuable over time.
My first startup was great as I went in at 25 with no college and only self taught tech skills. In hindsight, this was a great (probably only) way to start but pivoting to big tech would have been a better move instead of trying to strike it rich at a startup.
Also, the "Rest of the World" stock market capitalization is much larger than I would have expected, since it seems to exclude the largest exchanges (US+Europe+China+Japan). It would be nice to see a more detailed breakdown of that; perhaps I should do one :)
I would guess India+Brazil should be pretty large combined, and there are probably companies with tiny & illiquid float trading on obscure exchanges, but large capitalizations.
And yes, as another commenter noted, using the notional for derivatives valuation is really quite misleading -- I guess this is the easiest number to compute, and is probably the one supporting the point they are trying to make, but there should at least be more of a note telling people about it.
Still, nice work! It's good to see things in perspective.
Also think there are quite a few asset classes left out of this chart (although it is awesome!).
CalPERS (one of the largest worldwide pension funds) does an awesome annual report showing thier holdings. For me it is an awesome way to see all the different ways one can invest. Link: https://www.calpers.ca.gov/docs/forms-publications/annual-in...
Inside Job: https://archive.org/details/cpb20120505a
It's about how US executives created the financial crisis back in 2008 and is pretty relevant here. I'd well recommend watching it...some of the information provided is uniquely depressing and terrifying.
Willie Sutton: "I rob banks because that's where the money is."
You: "Amateur."