$700 trillion in global OTC derivatives? Behind the number
March 31, 2014
Financial derivatives are a useful tool for hedging risk. They can also enhance liquidity, cut transaction costs, and make the price discovery process more efficient. Regardless of these benefits and the fact that companies have used derivatives for decades to hedge risk, these instruments were the subject of widespread debate during the financial crisis that erupted in 2007 and its aftermath.

The "systemic-risk" concerns associated with derivatives trading stems largely from the gigantic scale of the global over-the-counter (OTC) derivatives market. According to June 2013 data from the Bank for International Settlements, it weighs in at $693 trillion in notional amounts outstanding. By this measure, the market is approximately 10 times as large as world GDP. That mind-bending number is also several times the size of other global financial marketsiEUR-specifically, eight times the bond market and 13 times as vast as the aggregate value of stocks.

This almost $700 trillion, which is often cited in the news media, is commonly used to measure the overall activity and size of the market. However, there are at least three reasons we should not use this figure to assess its place in finance and potential dangers lurking.

First, the notional amount does not reflect the assets at risk in a derivatives contract trade. It refers to the value of underlying assets specified in the contract, but does not represent the amount exchanged in a transaction, which would generally be the amount at risk. For example, suppose an investor buys a derivatives contract from a bank to hedge the credit risk of holding $1 million in IBM bonds. Assume further that the investor pays an annual fee of $1,000 over the length of the contract in exchange for a one-time payment equivalent to the bondaEUR(TM)s par value if IBM were to default on its debt.

In this case, the bond is the underlying asset and the $1 million is the notional amount. The $1,000 fee or cash flow obligation of the investor (the "counterparty") is the fair value of the contract and the amount at risk for the bank. The sum of the fair values (or cash flow obligations) of the outstanding contracts between the two parties is known as "gross market value." According to BIS, the gross market value of the global OTC derivatives market is $20 trillion, only 3 percent of the notional amounts. By this measure, the global bond market, the global stock market, and the world economy are about four times, three times, and four times as large as the global derivatives market.

Second, the notional amount outstanding overstates OTC derivatives trading activity because it represents the cumulative total of past transactions, even though the net exposure is reduced. To make this easier to understand, look at how exchanged-traded transactions are recorded. Trading derivatives through an organized exchange is recognized as more transparent because exchanges use a central counterparty (CCP) to clear and settle trades. Trading of an existing contract is netted by a CCP, who takes the opposite position in the same contract. That leaves the notional amount outstanding the same or smaller. In the OTC market, where transaction terms are privately negotiated, traders may enter into a new transaction to hedge out a previous one. However, in recording the transaction, the notional amount of the new contract will be accumulated to past transactions.

Third, it is important to distinguish among the different types of derivatives. Remember the meltdown of AIG? The insurance giant's financial problems related mainly to credit default swaps (CDS). According to the U.S. Financial Crisis Commission, OTC derivatives were among eight major factors that contributed to the systemic calamity, and in its Final Report, the panel noted that a "key OTC derivative in the financial crisis was the credit default swap."

Prior to the crisis, AIG issued almost $2 trillion of CDS on mortgage-backed securities and charged relatively small fees, considering the risk building in the housing market. When housing collapsed, AIG went down with it. In 2013, CDS accounted for about 4 percent of the total notional amount of OTC derivatives, according to BIS. That's a much smaller proportion than the 10 percent it reached in 2007. Interest rate and foreign exchange derivatives now account for almost 90 percent of total notional amounts.

Nonetheless, reforming OTC derivatives is essential to strengthen market stability and public confidence. The events around AIG illustrate that the failure to assess risk, along with an absence of oversight, can jeopardize the financial system. In the aftermath of the crisis, there has been an ongoing process meant to improve transparency and reduce counterparty risks. Clearing is an important component of the push for reform. In contrast to past practice, Dodd-Frank regulations require, with some exceptions, that OTC derivatives be cleared by a derivatives clearing organization and that transactions are done on swap execution facilities or designated contract markets. When their impact becomes clearer, it will be essential to assess the effectiveness of these incremental reforms over time.

For a comprehensive analysis of the growth and recent trends in the global derivatives market, see the Milken Institute study "Deriving the Economic Impact of Derivatives: Growth Through Risk Management."