What Are Derivatives and Why Are They Dangerous?

As we recounted in the preface to our derivatives timeline, though derivatives were not the sole cause of the financial crisis, they were a crucial factor.

What are derivatives?

Derivatives are financial instruments whose value is derived from an underlying asset (stocks, bonds, commodities, etc.). Traders can swap interest rates, take bets on whether a firm will go bankrupt, safeguard against future asset price increases, etc—all under the ugly umbrella term derivative. The concept of a derivative has been around for centuries, but their use has recently exploded, as demonstrated in our timeline and in the images below.

Derivatives are recorded in what’s termed as notional value, which just equals the value of the underlying asset on which the derivative is based. So if the underlying asset equaled $500 million, the notional value would be $500 million even though the megabank doesn’t actually trade $500 million. They just trade the derivative. It’s complicated if you’re totally unfamiliar with this market, but at least you can see why the global notional value for the derivative market can reach into the hundreds of trillions as shown above. It’s because the megabanks are recording the notional value.

Some traders don’t think people should worry about the notional value since it’s not referencing what is actually being traded. But the notional value matters because if the underlying asset turns toxic, then the derivative itself does too.

We saw this in the 2007-08 crisis: when underlying mortgages went bad, then all the derivatives contracts on top of those mortgages also went bad, and this worsened the crisis tremendously. So the notional value of derivatives matters, and you can see from the charts above that Wall Street in 2012 is a completely different world compared to Wall Street in 2000 (when the total notional amount was less than $100 trillion). In other words, the dangers of the derivatives market are still very much with us.

So, why are derivatives dangerous?

1. Derivatives allow for phony accounting

Charlie Munger once asserted that “to say that derivative accounting is a sewer is an insult to sewage.” Well said, Munger. Derivatives allow firms the option to record profits today that will supposedly come tomorrow. This way a firm can put on a good pony show today and get a better stock price. All is well—unless tomorrow’s profits don’t arrive as expected (because of an unforeseen fiasco). If this happens a seemingly healthy firm can suddenly implode, all because of phony accounting—as happened with Barings Bank, Enron, and Lehman Brothers.

2. Derivatives obscure the market

Several derivative contracts can be written on a single underlying asset, a feature which adds enormous complexity to financial markets. A derivative contract on one asset might be traded in Asia and the US, while another contract on the same asset might be traded in Europe. What’s more, the majority of derivatives are over-the-counter, meaning they aren’t standardized or traded on public exchanges. So the terms of each contract can vary greatly and so the implications and interconnectedness of this market can be impossible for regulators and traders to see clearly. When markets melted during the 2007-08 crisis trading halted in part because market players couldn’t readily discern which firms were on the brink of collapse and which firms were safe. This was partly because of all the derivatives contracts on top of the crumbling mortgage market.

3. Derivatives concentrate risk

Four US megabanks—JPMorgan, Bank of America, Citi, and Goldman Sachs—have a notional amount of $214 trillion in derivatives exposure. That’s more than 30% of the worldwide amount just in four US banks. When firms have such concentrated derivatives exposure, they leave themselves open to surprise losses like last year’s $6 billion London Whale loss at JPMorgan Chase.

4. Derivatives allow megabanks to take on more debt

Megabanks trade risk via derivatives contracts to another firm while keeping the underlying asset on their books. 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. Lehman Brothers experienced this after they’d borrowed 30 times more money than they had in reserve. In that case a relatively small loss of 3% meant that Lehman no longer had reserves (i.e. capital), and they therefore collapsed.

5. Derivatives deceive smart people into thinking they’ve eliminated risk

It keeps happening, over and over. “The smartest men in the room” think that they’ve figured out some way to eliminate risk completely through the use of derivatives. One amazing example of this is the tragedy of Long-Term Capital Management. A group of highly intelligent economists and traders created a hedge fund in the late 1990s centered around a formula which supposedly hedged risk completely. For the first few years, the fund made enormous returns and the creators of the formula even won the Nobel Prize for economics. But then they borrowed more and more money thinking they were safe in doing so (similar to Lehman), and when a series of unpredictable events occurred in world markets, they lost billions of dollars and put US markets in danger. Their downfall should have been a warning sign about the dangers of derivatives-related risk, but several other firms suffered similar fates in the following decade. If things remain the same, we’ll see the same results.

Interested in learning more? See our derivatives timeline.