The Bank for International Settlements (BIS) is reporting Derivatives traded on exchanges surged 27 percent to a record $681 trillion in the third quarter.

The amounts are based on the notional amount underlying the contracts.

  • Interest-rate futures, contracts designed to speculate on or hedge against moves in borrowing rates, led the increase with a 31 percent increase to $594 trillion.
  • Trading in stock index futures and options rose 19 percent to a record $81 trillion in the third quarter, as investors speculated on whether the credit-market losses would spread to the equity markets.
  • Trading in currency futures and options increased 18 percent to $6.4 trillion, the BIS said.

Investors may have shifted some trading to exchanges from the over-the-counter market to reduce the risk of counterparties defaulting on deals, the BIS said.

Does Anybody Trust Anybody?

Read the last paragraph in the above article carefully.

Already banks no longer trust each other and/or are so capital impaired they cannot or will not lend to each other overnight. Washington Mutual is the latest casualty in that regard. See WaMu Cuts Dividend and Jobs, and Prices Preferred Stock in response.

Now we find out that there appears to be a growing suspicion about the possibility of counterparties defaulting on derivative deals. Given that derivatives are ten times the global economy that suspicion sure seems justified.

Credit Market Fueled Record Derivatives Activity

BIS says credit market problems fueled record activity in derivatives.

The Bank for International Settlements said the summer’s credit market troubles led to record activity on derivatives exchanges but weighed heavily on bond issuance.

Growth in transactions between banks and other financial institutions was particularly strong, consistent with the increasing importance of hedge funds, portfolio diversification by institutional investors, such as pension funds, and an expansion in technical trading. BIS analysts also noted a marked increase in turnover involving emerging market currencies.

Hmmm. An expansion in technical trading and hedge funds are also a factor. Nothing quite like 10,000 hedge funds levered up 10-1 or higher betting on chart patterns adding up to enormous multiples of the world’s economy.

Derivatives Legal Issues

While on the subject of derivatives we may as well throw in a bonus item: Wall Street in legal trouble over derivatives prospectus.

The New York state Attorney-General has sent subpoenas to banking giants after announcing an investigation into the sub-prime market crash. According to the New Zealand Herald, Atty Gen Andrew Cuomo has sent subpoenas to several banks, including Bear Stearns, Merrill Lynch and Deutsche Bank.

The banks are being asked to show how they assessed the quality of the home loans underlying derivatives such as mortgage-backed securities and collateralised debt obligations (CDOs), the newspaper says. Mr Cuomo suggests that the banks creating the derivatives could be in trouble for failing in their legal obligation to ensure that prospectus information on the derivatives being sold was true.

Failsafe Prediction

I have a failsafe prediction: Several hedge funds are going to get carted out on a stretcher all at once and cause a cascade of defaults. Many hedges are in place that are based on other counterparty hedges paying off in the event of “an event”. When “the” event comes, those hedges will prove to be worthless.

Long Term Capital Management (LTCM) will look like a picnic in the park compared to the derivatives mess we are currently building up. For more on LTCM and the inherent systemic risks of leveraged derivatives please see Genius Fails Again.

Mike “Mish” Shedlock
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