A Global Derivatives Expert Shines the Light on Systematic Risk by David Galland

“A bank, especially an investment bank, is a fiendishly complicated institution. It is essentially a huge seething pot of current and future cash flows, the nature and risk of which change as the markets and the economy change.”

In order to better understand the tangled mass of derivatives overhanging the global banking system, we need to begin by defining some basic terms.

  • Market value: The amount of money actually at risk. Let’s say you bought a call option contract on 100 ounces of gold. The actual price of that contract in the marketplace (about $7,000 today) is the market value of the contract. As you will soon learn, a derivative is nothing more than a contract.
  • Reference: Your gold call option contract on the CME is said to reference 100 ounces of gold. A derivatives contract can reference any manner of assets, from stocks and bonds, to commodities and even other contracts.
  • Notional: In the case of your gold option, by multiplying the 100 ounces of gold by the gold’s spot price, say $1,360, we arrive at the notional value of $136,000. That only tells you something about the dollar amount of gold you control with your options contract. It tells you very little about the market value of the contract—i.e., the price at which you could unload your contract in the market.

Keeping those terms in mind, let’s define exactly what derivatives are. As will become clear in a moment, the topic is complex, and so, out of necessity, I will have to oversimplify.

A Derivative Is Simply a Contract

At the core of every derivative is a relatively straightforward contract between two entities. In the case of the gold call option above, that is a contract between you and the exchange.

Similarly, let’s say your bank, Bank A, has a portfolio consisting of $1 billion worth of mortgage loans, and you are a bit concerned about the risks inherent in that portfolio.

So, you wander down the street to Bank B and agree on a contract whereby you will pay Bank B a premium to assume of some of your risk in the unlikely case the loans in your bank’s portfolio suffer, say, a 20% loss.

You’re happy because you’ve reduced your risk by buying protection against an extraordinary loss. On the other side of the contract, Bank B is happy because it’s earning a nice stream of revenue from the premiums Bank A is contractually obligated to pay.

So far, so good.

Then It Starts to Get Complicated

As our story continues, the risk manager at Bank B comes to the conclusion that the bank has too much exposure to mortgage loans. So he heads down the street to Bank C and offers to sell them some of that risk, again for a premium.

Documents are drawn up for Bank C to help cover $100 million of the notional risk referenced by the derivatives contract between Bank A and Bank B. In exchange for agreeing to help cover that risk, Bank C will, again, earn a premium.

And just like that, the original straightforward agreement between two banks has become a complex, intertwined series of contracts—derivatives contracts—involving three banks, each of which now has exposure to hundreds of millions of dollars in counterparty risk.

To give you a sense of just how complex things have gotten at this point, I posed the above scenario to my banker friend and asked him to untangle it. Here is his explanation.

You want Bank A to get protection on the first 20%. In that case, the notional will be much higher than the $200 million it is trying to protect against risk. Let me explain.

What you describe is a put spread. Bank B is liable for any loss from par (100%) to 80%. That is, Bank B is short a 100% put and long an 80% put on a $1 billion portfolio. After that, it is still Bank A’s risk.

If so, the gross notional amount for Bank A is $3 billion, and for Bank B the total is $2 billion. The new trade is $1 billion of 100% puts and $1 billion of 80% puts for each bank. It doesn’t matter that the total amount Bank B could lose is only $200 million. That is the magic of gross notional.

If Bank C took half of Bank B’s risk, then Bank B would add an extra $1 billion notional to their total (500 x 500), as would Bank C. This is in spite of each only having a final exposure to a $100 million loss. Confused yet?

Net total loss exposure at the end is:

Bank A: $800 million

Bank B: $100 million

Bank C: $100 million

All of which add up to $1 billion, which is correct.

Gross notional exposure is:

Bank A: $3 billion ($ billion original asset value + $1 billion long 100% put + $1 billion short 80% put).

Bank B: $3 billion ($1 billion short 100% put + $1 billion long 80% put + $500 million long 100% put + $500 million short 80% put)

Bank C: $1 billion ($500 million short 100% put + $500 million long 80% put)

Total: $7 billion gross notional.

As I hope you can see, the gross notional amounts do not reflect real market risk.

Seeing the complexities involved with just two fairly straightforward contracts—between Bank A and Bank B, and then between Bank B and Bank C—it becomes clear why the vast majority of bankers have a hard time getting their heads around their total derivatives exposure.

Now multiply the number of intertwined multi-billion-dollar contracts by thousands. That’s how you arrive at the situation today, a Gordian knot of intertwined derivatives with a notional value of over a quadrillion dollars.

Enter the Regulators

While many dear readers may harbor a legitimate disdain for the meddlesome minions of the all-powerful nation-states, I have to give credit where credit is due. Post-2008, the banking regulators actually got the message on the systematic risks emanating from free-wheeling investment bankers.

They are now keenly aware of the risks inherent in the tangled web of derivatives contracts on the balance sheets of the world’s largest financial institutions, pension funds, etc.

Among other steps taken since the near-extinction event of 2008, regulators have been pushing the big banks to “net down” their derivatives contracts.

This simply means pushing investment bankers to review their derivatives contracts with the goal of finding those that are redundant or non-productive. When they do, the two parties are urged to essentially tear up the contracts and move on. No harm, no foul.

According to my friend, there has been quite a lot of this going on.

Yet, rather than reducing the overhang of derivatives contracts, all the push for net downs has accomplished is to slightly slow their proliferation. Since the 2008 housing crisis, the pile of derivatives has grown ever higher, and by a lot. Just at a somewhat slower pace.

Exchange-Traded Derivatives

Another initiative, legislated in the Dodd-Frank bill and being pushed hard by the regulators, is for the banks to standardize their derivatives contracts so they can be traded on exchanges and therefore priced in the marketplace, as opposed to over-the-counter or bilateral deals done behind closed doors.

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