Evercore Pan Asset

At the end of 2008 at the height of the Credit Crunch there were $600 trillion of outstanding derivative contracts, as measured by the BIS notional amounts outstanding. That was more than ten times the total national income of the world. Banks, investment funds and other financial institutions, along with others, had entered into bets on foreign exchange, interest rates, shares, commodities and credit defaults on a colossal scale.

We have lived through a painful couple of years of cutting risks, of repaying debts and sorting out some of the excesses of private sector credit. Yet by the end of 2010, the total sum in outstanding derivatives was still a mighty $600 trillion, still more than ten times world output. The biggest area is in interest rate contracts, followed by foreign exchange. Many businesses now wish to protect themselves against an adverse change in the value of currencies they receive for their work. They wish to avoid some of the adverse impact of rising interest rates.

The fact that there is $364 trillion at risk in interest rate swaps implies there is much more demand for these than you would expect from people and companies being prudent. Financial institutions seem to be in overdrive when it comes to taking views on future interest rates, with the outstanding amounts so much larger than total world activity. In contrast, commodity contracts are a more modest $2.9 trillion. These too, however, probably contain some that are taken out by financial businesses to increase risk or take a view, rather than by companies using commodities and wishing to protect their underlying positions in materials.

The area that is currently causing more concern is the $30 trillion in credit default swaps. Some commentators are asking what might happen if defaults in the weaker sovereign debts are triggered. The answer the Regulators hope for is that the amounts will be manageable, with the winners helping offset the losers from any such move in problem territories. The gross market values of all this activity are of course considerably lower than the notional amounts outstanding at some $21 trillion. On this measure credit default swaps are a less worrying $1.3 trillion, against $14.6 trillion in interest rate contracts.

It is a good thing that the Regulators in this post Credit Crunch world are puzzling over what in future might destabilise the system. Their exploration of the consequences of too much shorting in the market needs to be supplemented by examining this vast nexus of derivative contracts. The financial world has innovated, and has provided some excellent ways for people running real businesses to offset and manage risks. This is welcome. It has also enabled portfolio investors to manage some of their clients’ risks better.

It has also today created a vast superstructure over world GDP and portfolio investment now amounting to a notional $600 trillion. Regulators need to make sure this is proportionate, held sensibly on balance sheets that can stand it going the wrong way, and controlled through their controls on the banks that lie at the heart of all this activity.