Sometimes I can be very obstinate and unhelpful, and as with all of us I have particular bugbears that I can’t help but seize on in conversation. One of them is my seething resentment and annoyance when people say things like:
I am a derivatives market professional. I eat sleep and breathe them – hopefully you can discern this from my paper portfolio posts, I freakin’ love the things:
But just because I love them doesn’t mean I unconditionally support them in all circumstances. I think of derivatives as being financial firearms. One may be fascinated with firearms, own collections of them, and use them for target shooting, but that does not mean one has to think that all civilians should be issued with one and told to crack on. When I step up to defend derivatives in a public forum, it is not because I believe they are an unconditionally good thing, but because accuracy is important, and alarmism distracts us from addressing the very real systemic financial issues we have. So let me clarify what exactly my problem is with the way people talk about them.
Joel’s tweet above is the most irritating bit of alarmism of all. Let me say this once and for all. The notional ‘size’ of a derivatives contract bears only incidental relation to the risk of that contract. Size does not matter. The cleanest, neatest way to place a bet on whether a Central Bank hikes interest rates is to do an interest rate swap that starts on the day of the next rate setting meeting, and ends on the day of the meeting after. One enters into a contract to pay a fixed rate, and receive the overnight rate at which banks lend and borrow. In Europe, this is called an ‘ECB EONIA’ swap. The standard traded size for such contracts is EUR 2.5bio. WHAT? 2.5bio??? Yes. I have clients who manage only hundreds of millions of Euros who trade these with me pretty regularly. How can they do this? Well, look at the actual cashflows, and there are only 2, at the end of the swap:
Fixed rate payer pays Fixed rate * notional * number of days/360
Floating rate payer pays Average Eonia fixing * notional * number of days/360
Currently, the EONIA rate is -0.08%. Yes negative. Banks pay each other to borrow money. So let’s say I think rates will go up, so I enter into this swap as the fixed rate payer at -0.08%, from one ECB meeting date (15-Apr) to the one after (03-Jun). Now lets say I ballsed up, and the ECB cut rates by 20bp, so the average EONIA fixing over the life of the swap is -0.28%. Surely I’m screwed? That is the worst possible outcome for me – I was betting on higher rates and they cut. And I did EUR 2.5bio! OH NO!
Well, it’s bad but not that bad. Actually, I only lost EUR 681,000, so 0.03% of the notional of my trade. Y’all can check my maths!
Not only does notional not matter, netting does. If I enter into the above swap with one of my counterparties, I’m probably going to want to hedge it by doing something pretty similar. And then that next guy is going to do something pretty similar too. And so on. And all of those trades will be counted into that $700trio number, even though no one in the chain of transactions has much actual exposure to the underlying.
Now this isn’t to say that derivs are safe or that notional doesn’t matter. Clearly, trades with bigger notionals and all other details identical are bigger. Equally clearly, if my client goes bust owing me a tonne of money, and I’ve got an offsetting trade to another guy where I owe him money, I’m in trouble. In a world where banks have captured regulators so effectively that they guarantee themselves state support if they get into difficulties, that could be a problem for everyone, but the issues is not the derivatives here, it’s the lobbying that created a situation where a few big players run the entire game and can’t be allowed to go bust. Regulation is part of the problem here. Only a few large players can, in the age of Dodd Frank etc, afford the overhead of the massive compliance effort to run a modern swap dealing operation. This is not to say that all regulation is wrong, but it is to say that the dominant model of a few humungous firms dominating the financial markets is the real issue.
And this is my real problem with the entire conversation about Derivatives, especially amongst the left. It feels like when you discover the derivatives market for the first time, you’ve stumbled on the source of all financial instability. The crazy notionals the arcane terminology, the ‘lack of regulation’ (love that claim, try working on a swap dealing desk…) etc. But you really haven’t. There is no purported problem that derivatives cause, systemic instability, mis-selling etc, that couldn’t be solved by removing the enormous power of the few large banks who run the financial game. The issue, as ever, is too much power with too few people. The kind of ‘OMG, $700trio!’ alarmism that dominates most of the conversation obscures the structural issues at the heart of how the financial system exploits the rest of the economy to enrich a few white old men, and it doesn’t help solve the problems.
PS: I LOVE explaining derivatives and any other financial market topics of interest to people. So please, ask me.
Swap: a financial contract where two parties agree to swap one set of cash flows for another. Typically, the expected value of these flows will be the same.
Interest rate swap (market standard): the standard for interest rate swaps is to exchange a fixed rate for a floating one. For example, one might enter into a swap paying 1.5% annually, and receiving semi annually whatever the £ 6 month libor rate turns out to be.