Researchers at CERN, the European Organization for Nuclear Research, in Geneva, Switzerland, made a splash recently with the “discovery” of the Higgs boson — a subatomic particle thought to be one of the fundamental building blocks of all life. The Higgs boson was not actually found, mind you. What was found was a hint of the Higgs boson, because the particle itself is so difficult to measure. For physicists, its discovery is a big deal as it promises to complete the Standard Model theory of physics creating a vital link between matter and anti-matter.
For researchers at CFA Institute, the Higgs boson discovery is interesting because it parallels a great challenge facing the world of finance: derivatives. You see, in finance, derivatives contracts are kind of like the Higgs boson as they contain the vital link between money and anti-money.
What does anti-money mean? In today’s modern banking system, the Federal Reserve creates money — dollars, cents, coinage, etc. This is known as the monetary base. Then the banking system expands the monetary base many times over by creating credit (i.e., loans) — effectively lending out more money than they actually have in their vaults (also known as fractional reserve banking).
Once the monetary base is expanded, it then becomes the money supply. Because the money supply is a function of bank loans, the money supply itself is constantly subject to aggregate changes in credit. So, the performance of loans, net issuance of loans, as well as the rise and fall of aggregate credit have an impact on the money supply. As aggregate credit expands, the money supply expands. Likewise, as aggregate credit contracts, the money supply contracts — all else being equal. Therefore, if a large enough amount of obligations came due simultaneously, then it would cause the money supply to contract — hence, anti-money.
So, in a catastrophic credit event, the obligations spawned by derivatives contracts would cause the money supply to shrink in a material way.
Alas, all else is not equal. The Federal Reserve actively tries to manage the money supply in part by expanding credit. So, whether or not central banks can manage the excess debt is a big question. A bigger question still is whether or not central banks can manage the impact of obligations spawned by the massive derivatives market in a catastrophic credit event. Little wonder that derivatives are now the single greatest concern for professional investors (see a recent survey of CFA Institute members as highlighted in "Derivatives Danger").
Central banks, of course, are not the only reason that governments have excess debt. As outlined in "Competitive Currency Devaluation: The Feeding Frenzy," countries like the U.S. have had ever greater trade deficits and are now carrying enormous fiscal deficits. In addition, the world’s accumulation of debt has been absolutely enormous, with total outstanding debt now pushing $200 trillion. Amazingly, the aggregate outstanding debt pales in comparison to the amount of outstanding derivatives. According to the Bank of International Settlements (BIS), the aggregate amount of outstanding OTC derivatives is $707 trillion as of June 2011.
Notional Value of Outstanding OTC Derivatives ($ in Billions)
Source: Bank of International Settlements(BIS).
Of course, this only captures what has been reported to the BIS. Various other sources set the figure at more than a quadrillion dollars when both the listed derivatives and OTC derivatives are included. And because we have no practical experience dealing in quadrillions, we need some context for these mind-boggling amounts: If you had a quadrillion pennies stacked up, it could reach from the Sun to the outer reaches of our solar system.
According to research published by the Federal Reserve Bank of Dallas in 1998, the reason behind the explosion in derivatives was due to the world exiting the gold standard in 1971. Once the “free currency exchange” system was adopted, there was a substantial increase in volatility, particularly with respect to interest rates. Interestingly, in this same paper, the author argues that derivatives do not merit special attention, citing that past events, such as the bankruptcy of Orange County, did not spawn a catastrophic collapse. And, before that horrific crash in Lakehurst, New Jersey, the Hindenburg successfully completed a round trip to Rio de Janeiro. Simply put, "it hasn’t happened before" is not an argument — it’s a cop out.
Moreover, the world is now grossly overindebted, meaning that most governments have little to no room to paper over problems with more debt. So, it is at least conceivable that various government actions to arrest the debt crisis by printing more money could lead to inflation and/or declines in economic activity. What probability this outcome has is anyone’s guess, but it is clearly nontrivial given the staggering amounts of debt and pervasive government deficits. And it is such a decline in economic activity that could set in motion a daisy chain of events causing massive growth in obligations that need to be met — or anti-money.
So, what can be done about this problem? For starters, the aggregate amount of outstanding derivatives on a specific underlying asset should be capped such that the aggregate obligations spawned by a specific set of derivatives cannot exceed the value of the underlying assets. As cited above, total worldwide debt is approaching $200 trillion. This figure compares to the aggregate notional amount of outstanding OTC derivatives of a minimum of $707 Trillion.
Moreover, comparison of these figures says nothing about who owns what. Many of the owners of the bonds/loans outstanding are not hedged in any way. And many of the owners of the derivatives are naked — making speculative bets and do not own the underlying assets. So, the problem is even worse than it first appears.
That said, the need for a rational constraint on the derivatives market needs to be offset by the need to protect the freedom and flexibility of investors so they can serve their clients’ interests.
Like the Higgs boson discovery, the systemic collapse of the financial markets in 2008 gives us a hint of the destructive power of derivatives. As researchers at CERN gather data, they feel confident that they will soon know whether or not the Higgs boson actually exists. Likewise, many professional investors feel that the escalating debt crisis, particularly in Europe and Japan, will soon demonstrate just how much anti-money derivatives can produce.