This paper takes a look at the basics of derivatives involving commercial banks, a subject which is relatively dense, but of great interest all over our financial world... One of the conclusions of this paper is that the sheer magnitude of derivative instruments combined with the principle of credit risk or assumed credit risk makes for a potentially devastating banking crisis. I am going to go over the basics of these issues in this paper, and provide reference material for those who want to delve into this in more detail. The figures are from the beginning of 2003, and the actual figures are much higher today.

What a derivative contract is in general:

A derivative contract is basically a contract between two parties that is linked to interest rates, currency exchange rates or indexes. The derivative contract links the holder of the contract to the risk and rewards of holding or owning a financial instrument, but without actually holding the instrument. It has tremendous leveraging effects.

There are three main areas of derivative activity. Hedging, dealing and speculating. Hedging is done by businesses to limit their risk exposure to interest rate changes for example. Dealing is the market making by banks to earn fees on derivative contracts, and provide the market for businesses to hedge or speculate. Speculation is the entry into a derivative contract without some or all of the offsetting components that are in hedging contracts.

Speculators can achieve incredible leverage, but assume most or all of the risk of the contract. Hedging is less risky because the contracts are offset. The dealer banks are subject to counter-party risk of the parties entering into the contract in any of these derivative activities. Dealer banks may also assume some of the risk in the hedging contract by not completely offsetting the risk of the hedge. Thus, by making a market, a dealer bank can open a completely offsetting hedged derivative contract, or it can assume some of the market risk itself.

This paper provides figures for the purpose of instruction, from the FDIC as of March 2003, and the associated document is included as a link at the end of this paper. As of December 31, 2002, derivatives at commercial banks measured a total notional value of over $56 trillion, and continued to grow dramatically. The FDIC states that derivatives perform an essential role in the US and world economies, but they also pose risks to the FDIC.

Upon examining the FDIC paper linked here, I have found that, rather than allaying my concerns about derivatives, I have found no comfort at all. In fact, yes my freinds, derivatives are basically big bets made with heretofore unattainable leverage, and in amounts that are simply astounding, even to financially savvy mindsets. They expose not only the holders of the derivatives contracts to the risk, but the dealer banks as well if the holders default, (counter-party risk).

One of the principles of derivatives is that the risks are managed, but only to the extent that things are foreseen in the model. UNEXPECTED events are highly dangerous as a result. The LTCM crisis resulted from the unexpected defaults of Russia, and the holders of the derivatives related to those defaults experienced cascading losses, resulting in defaults and counter-party defaults.

Of the $56 trillion in derivatives outstanding in the beginning of 2003, 86 percent were interest rate contracts. The remaining 14 percent of the derivatives in the mentioned FDIC study are foreign exchange contracts and equity, commodity, and other contracts.

Basic example, interest rate contracts.

Interest rate derivative contracts are by far the majority, so lets take a look at an example of one of these to get an idea of the concept:

Transaction 1: An Interest Rate Swap
Party A agrees to pay party B a fixed rate of 6 percent and receive from party B the 3-month Treasury rate for a period of 2 years beginning November 15, 2000, on a notional value of $1 million. Party A would enter such a transaction either to profit from a view that rates were going to rise or to hedge a balance sheet position that was subject to erosion in value if rates were to rise, such as holding Treasury bonds. If the short-term rate falls, Party A will lose on its derivatives position. Assuming for simplicity that the 515 basis point decline in 3-month Treasury rates that actually occurred during this contract period was evenly distributed over the two years, Party A would have lost a little more than $57 thousand in the transaction less than 6 percent of the notional value. (footnote 1).

For a $1 million notional amount the risk seems manageable. But that is not the kind of number I am really looking at here. To be frank, This example shows me that, rather than allaying fears, it simply illuminates the extent of the risk. Since interest rates are changing a great deal at this time, the sheer magnitude of the amount of interest rate derivatives (86% of 56 trillion) pose very large risks indeed. And of course, the amounts of derivatives open today are much higher than in the beginning of 2003.

Assuming ONLY 500 BP movement, at 86% of $86 trillion, the market in interest rate derivatives is exposed to $240,000,000,000 of risk. That is astounding. The issue here is that the sheer magnitude of the contracts expose the system to levels of loss and credit exposure never before seen. If any party in these contracts default, the dealer banks have to pony up. If the dealer banks default, the FDIC ponies up. There is no way to mitigate this risk. Frankly, this is horrifying to me, and confirms the doubts I had about derivatives before I commenced this study.

The majority of the derivatives positions held by commercial banks are tied to interest rates, and if those rates move in unforeseen ways the amounts at risk to the contract holders and market makers are huge. The next example is the equity contract derivative.

Transaction 2: An Equity Contract
Party A agrees to pay party B a fixed rate of 6 percent and receive from party B the return on the NASDAQ composite for a period of 2 years beginning November 15, 2000, on a notional value of $1 million. Assuming, again for simplicity, that the almost 45 percent decline in the NASDAQ that actually occurred during the contract period was evenly distributed over the two years, Party A would have lost almost $343 thousand in the transaction more than 34 percent of the notional value. (footnote 1)

In example 1, The FDIC states the difference of notional value of 1 million, versus the actual risk of a 515 BP loss of $57,000 indicates that the risks of the interest rate contract are low, relatively speaking. They make the comparison to example 2, a derivative contract based on a market index such as the NASDAQ. A similar $ 1 million derivative contract based on the NASDAQ would result in a $350,000 loss based on a 35% fall in that index.

So their idea is that interest rates aren't as volatile as a stock index, and then only represent a small change in an interest rate, and not notional value. However, I maintain that the sheer size of the interest rate derivatives market makes it compare rather negatively in this light, since even the smaller numbers of the interest rate movement are magnified by the incredible numbers of the contracts, numbers like 86% of $56 trillion.

One final clarification about offsetting risks.

There are three basic types of derivatives, offsetting, market, and positional, but only the offsetting ones are, well offsetting. Even the offsetting positions are subject to counter-party risk. The other two, market and positional derivatives, are not offsetting, but rather expose the holder and dealer/market maker to highly leveraged risk.

Counter-party risk is the Achilles heel of the derivatives market.

If any one party defaults, a cascade of time dependent defaults follows. Since the amounts involved are so huge, any weak link is a major risk to the system. As of today, interest rates are moving. So, since the majority of derivatives are tied to interest rates, and interest rates are in flux right now, this is a time of higher risk than we have seen in recent years.

For more reading on this subject please read the following informative FDIC document:

www.fdic.gov/bank/analytical/fyi/2003/032603fyi.html#ft7 (1)

Chris Laird
tec_10000@yahoo.com

17 May 2004