Derivatives Markets Could Cause a Financial Crisis
A financial crisis could be looming and investors could be in a world of hurt in the coming years.
You see, a call for a financial crisis may sound like an out-of-this-world idea at the moment, and there isn’t anyone talking about it. But there’s one place that says it could be possible and not many are paying attention to it.
Look at the derivatives market. Warren Buffett calls derivatives financial weapons of mass destruction. But over the past few years, we have seen banks get more active in this market.
Remember, it was derivatives that caused the previous financial crisis. This time around, they could do the same.
Consider that at the end of the third quarter of 2018, the top 25 banks in the U.S. had derivatives that had a notional value of close to $207.0 trillion. Please note that is not a misprint. (Source: “Third Quarter 2018: Quarterly Report on Bank Trading and Derivatives Activities,” Office of the Comptroller of the Currency, last accessed January 30, 2019.)
The U.S. gross domestic product is roughly around $19.0 trillion. So, the notional derivative amount is roughly 11 times bigger than the size of the U.S. economy.
One could ask, “Aren’t the derivatives used to hedge portfolios and business transactions?”
Yes, surely, derivatives could be used as a hedging tool.
But know that derivatives are essentially a contract between two parties. The funny thing is, both parties think they are correct until the time of maturity of the contract comes.
So What’s Really the Issue?
Of the $207.0 trillion worth of derivatives, nearly 76% are based on interest rates.
If you even remotely follow the financial world, you would know that the Federal Reserve is raising interest rates. As this is happening, we are seeing yields on bonds and other interest rates sensitive instrument moving higher as well.
This is where the problem comes in…
If we assume just a small portion of these derivates go “bad,” given the uncertainty around interest rates, what will happen?
Dear reader, I believe derivatives are worth watching closely.
I know $207.0 trillion is just the notional value and their actual value is completely different. However, derivatives are very complicated. Remember the famous “Whale trade” by a trader at JPMorgan Chase & Co. (NYSE:JPM)? It was a derivative trade where a trader lost a massive amount of money for the bank. And that was just one trade going bad.
If just 10% of these derivatives go bad, that’s $20.7 trillion on the line. I think that amount would be more than enough to do a lot of damage. We could see a bunch of bank failures and have a financial crisis at hand.
Know that the top 25 banks in the U.S. don’t even remotely have enough assets to cover for all the derivatives out there. At the end of the third quarter of 2018, their assets amounted to just $11.04 trillion. So for every $1.00 of assets, they have derivatives of over $18.00.
I will end with this; in case there’s a financial crisis, it could be much more severe than the last one. I reiterate, be very careful.