The next major threat to the international financial systems is very likely to come from reckless investors gambling with derivatives, the dangerous betting vehicles that contributed to the 2008 collapse of much of the economy.
Derivatives are the financial instruments that helped push the global economy to the brink in 2008, taking down American International Group (AIG) and Lehman Brothers Holdings, igniting the worst recession since the 1930s.
Used properly, simple derivatives (literally: a financial asset that "derives" its value from that of an underlying asset) can reduce the risk of some financial transactions. To use a simple example, they can help bankers guarantee what price they'll have to pay for wheat two years from now.
But big-money gamblers can invest in any of a number of highly risky, extremely complicated kinds of derivatives for purely speculative purposes. When this happens, derivatives are just a form of very dangerous, virtually no-limit, betting.
Charlie Munger, who was Warren Buffet's right-hand man for years, once asserted that "to say that derivative accounting is a sewer is an insult to sewage."
Oddly, and totally inappropriately, derivatives allow firms the option to record profits today that will supposedly come tomorrow. But if the bets are big and tomorrow's profits don't emerge, a financial house could implode.
CHEATING THE SYSTEM
Derivatives allow firms the option to record profits today that will supposedly come tomorrow. "Several derivative contracts can be written on a single underlying asset, a feature which adds enormous complexity and risk to financial markets," points out the website Too Big Has Failed.
And here is where it gets really dangerous.
"Megabanks trade risk via derivatives contracts to another firm while keeping the underlying asset on their books," says Too Big Has Failed. "This way they can bypass capital requirements and take on more debt. This in turn allows them to make more trades, but it also means that if a sudden downturn surfaces in the markets, the firm which borrowed way beyond their means may quickly go bankrupt."
Here's what did happen, and can happen: Lehman Brothers borrowed 30 times more money than they had in reserve. In their case, a relatively small loss of three per cent meant that Lehman no longer had reserves (i.e. capital), and they therefore collapsed.
Another one blew up last year. Two former JP Morgan Chase employees are facing criminal charges related to a derivatives trading scandal last year in London that cost the bank $6.2 billion -- enough money to run the city of Vancouver for more than five years. The bank also tried to hide its losses from investors and federal regulators.
If a number of derivatives go bad at the same time other crisis events occur, much of the world's economy could be heavily damaged.
When the gambles do work, derivatives can be very profitable. In fact, they are the world's most profitable and secretive financial product, earning some $50-billion a year for both legitimate businesses and financial traders.
Today, while regulators struggle with banks to get the derivatives market under control, these gambling instruments are being used just as dangerously as they were leading up to the recession. In fact, the banks and traders are even more aggressive now.
The value of derivative bombs smoldering away around the world waiting to explode, is almost uncountable. The derivatives market is so poorly tracked that economists can't agree within trillions of dollars as to its real value.
Let's go with the conservative estimate of the International Swaps and Derivatives Association (ISDA). They believe that, as of the end of 2012, over-the-counter notional derivatives were worth US $606-trillion.
In comparison, the gross world product (GWP) in 2012, the total of all the real goods and actual services produced on planet Earth, was about US $84.97 trillion -- less than one-seventh the value of the derivatives market.
As derivatives are traded in microseconds by computers, we really don't know what will trigger a crash, or when it will happen. Indeed we have even seen computer glitches themselves almost crash the stock market.
But several international banks have huge liabilities associated with derivatives. In the U.S. alone, JP Morgan Chase has about $70-trillion in derivatives, but is holding only about $2 trillion in deposits and other assets. Bank of America has about 30 times its assets in derivative bets; Citigroup and Wells Fargo have each bet many times their assets on derivatives.
The risks are particularly high in the U.S. because of the concentration of derivatives ownership. Ninety-five per cent of all derivatives there are held by just five megabanks and their holding companies. The top executives from the leading banks meet monthly -- in secret -- to make sure their firms continue to control the derivatives market.
Mike Krauss, a founding director of the U.S. Public Banking Institute, said in August he believes "the biggest banks on Wall Street really aren't safe; they've got so much exposure in derivatives and who knows what else -- they're in danger of going down and taking depositors with them."
U.S. BANKS BLOCKING REFORM
Regulators in the U.S. and Europe have been trying for three years to get the banks to agree to laws that would reduce the risk of a repeat of the mayhem that occurred when Lehman Brothers collapsed. Both are taking similar approaches to controlling derivatives.
Roger Lowenstein of Bloomberg news writes that regulators want "to bring the derivatives business out of the shadows--first to get a handle on systemic risk, second to create greater price transparency and narrower margins in a business dominated by a handful of banks, and third to protect the sort of customers who shouldn't be playing with matches."
Big banking is fighting back with what it has most of: money and influence. Says Lowenstein: "The derivatives industry is squeezing Washington like a python." And Washington backed off.
"Under the three-year assault, the CFTC [Commodity Futures Trading Commission] created winners and losers with keystrokes," writeBloomberg's Silla Brush and Robert Schmidt. "Changing a single number in one rule undermined potential competition to banks. Another tweak allows firms including Koch Industries Inc. and ConocoPhillips to trade billions of dollars in swaps and avoid the most stringent rules."
One element regulators will be relying on is the creation of derivatives clearing houses. In addition, U.S. officials seem to be satisfied if, in the event a bank does go bust, derivative holders will allow a cooling-off period before demanding that their claims be settled. Authorities believe this would give them time to (hopefully) transfer the contracts to parties that are not in danger of collapsing.
It appears that yet-to-be finalized U.S. laws will apply to perhaps 20 per cent of the global derivatives market. Large and important parts of the derivatives trade will be exempt.
But we should be worried that authorities do not seem able to control the dark side of the financial business. Last year global authorities were shocked when 13 huge banks and hundreds of traders were involved in a conspiracy to manipulate the Libor rate, a key world interest rate. Moreover, practically every big bank in the world has entered guilty pleased to charges of fraud since the recession.
If the big banks and market manipulators created the largest derivative gambling scheme ever, and it crashed, the result could be the collapse of a huge section of the world economy. Obviously, regulators have to try harder to get control of the market so this would be impossible.
Read other articles by Nick Fillmore on his blog, A Different Point of View.