Derivatives: Dangerous CrossCurrents

02/16/2017 9:00 am EST

Focus: STOCKS

Alan Newman

Founder, Crosscurrents Publications, LLC

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. However, there is no way to address a solution to all potential derivative events, thus mistakes have continued to occur.

It only took 11 years for another event, when the massive derivative portfolio of Long Term Capital Management (LTCM) was tested and failed.

While this event was focused on bonds, the sheer size of LTCM's portfolio insured trouble if their bets went wrong. They went very wrong. Again, we witnessed the cascade effect and again, we were likely only hours from a total collapse.

Only nine years later, we were forced to suffer yet another debacle triggered by massive wrong bets by Bear Stearns and Lehman Bros.

Now, only four banks dominate various types of derivatives. The largest category is Swaps and four banks hold $92.8 trillion in Swaps - a 90% share.

For the smallest category of Credit derivatives, the big players have a 97% share. The big banks overall share for the four categories listed is 90%.

Derivative contracts such as Swaps and Credit derivatives, are written based on assumptions that the markets will function within certain parameters, which we can defined as normal expectations. The trouble is that "normal" can never be guaranteed.

In practice, the success of any single contract always inspires more. While risk exposures may seem minimal when contracts are written, no assumptions can be legitimate when the very size of the derivative markets dwarf everything else.

As we have seen before in 1987, 1998 and 2007, "normal" can metamorphose into "disorder" in only hours. It doesn't take a genius to discern the gaps between these events average roughly 10 years.

Clearly, there is no way to reasonably forecast the time at which normal flips to disorderly. The Black Swans of 1987, 1998 and 2007 were not supposed to occur - but they did.

The alleged odds for such events are so remote, they cannot be entertained by traditional analysis, yet three such events in 20 years should be proof the odds are larger. Another derivative event will happen. We just can't predict when.

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