October 14, 2011 at 11:05 AM EDT
Derivatives – The $600 Trillion Time Bomb Set to Explode
Derivatives played a crucial role in bringing down the global economy, so why are world's top policymakers not reining them in?

pocket_watch_in_hand_185Do you want to know the real reason banks aren’t lending and the PIIGS have control of the barnyard in Europe?

It’s because risk in the $600 trillion derivatives market isn’t evening out. To the contrary, it’s growing increasingly concentrated among a select few banks, especially here in the United States.

In 2009, five banks held 80% of derivatives in America. Now, just four banks hold a staggering 95.9% of U.S. derivatives, according to a recent report from the Office of the Currency Comptroller.

The four banks in question are JPMorgan Chase (NYSE:JPM), Citigroup (NYSE:C), Bank of America (NYSE:BAC) and Goldman Sachs (NYSE:GS).

Derivatives played a crucial role in bringing down the global economy, so you would think that the world’s top policymakers would have reined these things in by now — but they haven’t.

Instead of attacking the problem, regulators have let it spiral out of control, and the result is a $600 trillion time bomb called the derivatives market.

Think I’m exaggerating?

The notional value of the world’s derivatives is actually estimated at over $600 trillion. Notional value, of course, is the total value of a leveraged position’s assets. This distinction is necessary because, when you’re talking about leveraged assets like options and derivatives, a little bit of money can control a disproportionately large position that may be as much as 5, 10, 30 or, in extreme cases, 100 times greater than investments that could only be funded in cash instruments.

The world’s gross domestic product (GDP) is only about $65 trillion, or roughly 10.83% of the worldwide value of the global derivatives market, according to The Economist. So there is literally not enough money on the planet to backstop the banks trading these things if they run into trouble.

Compounding the problem is the fact that nobody even knows if the $600 trillion figure is accurate, because specialized derivatives vehicles like the credit default swaps that are now roiling Europe remain largely unregulated and unaccounted for.

Tick…Tick…Tick

To be fair, the Bank for International Settlements (BIS) estimated the net notional value of uncollateralized derivatives risks is between $2 trillion and $8 trillion, which is still a staggering amount of money and well beyond the billions being talked about in Europe.

Imagine the fallout from a $600 trillion explosion if several banks went down at once. It would eclipse the collapse of Lehman Brothers in no uncertain terms.


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