Derivatives: Dangerous CrossCurrents
Our long held theory is that excessive growth in the utilization of derivatives has added greatly to systemic risk and has impeded long term economic growth, cautions Alan Newman, editor of CrossCurrents.
In our view, the expansion in notional values of derivatives is the most significant development for the financial markets and the economy in the 27 years we have published Crosscurrents.
The core of our thesis is the absolute dominance of too few players holding monstrously large drivative portfolios. Experience has shown that the concentration of trillions of dollars of notional values in only a handful of banks has the potential to disrupt the markets. It's not a guarantee of disruption, only a indicator of what occur.
Simply put, the odds of an unmanageable dislocation sharply when risks are on the shoulders of too few players; and when the markets break, they break hard.
When stocks peaked in 1987, the entire capitalization of the market was
roughly $3.2 trillion. At its peak, "portfolio insurance" totaled $90 billion,
roughly 2.8% of total market cap.
Unfortunately, the mechanics of the scheme directed portfolio managers to sell stock index futures when the market fell?by 3%. It worked quite well when stocks were rising and when the inevitable modest corrections ensure.
However, when the market was faced with a heavy sell off, all preconceived ideas of how things would work went out the window and the market crashed 22.6%.
Of course, lessons were learned and adjustments were made so that a similar occurrence might never again erase that much value in one day.