ralfy wrote:If the liquidity pyramid presented in this
site is right, then total miscellaneous assets which you mention are worth $125 trillion worldwide.
In contrast to that, the notional value of total derivatives is $1,600 trillion.
I believe the damage that the notional value of derivatives could cause, comparing that total number to the number of underlying assets is VASTLY overstated and wildly misunderstood by most people.
Let's take a common, fairly safe, well managed, capitalized, regulated, and (relatively speaking) easy to understand derivative market that is huge.
Stock options on major exchanges.
The average risk of such options is TINY compared to the notional value for multiple reasons.
First, puts and calls move in the opposite direction when the underlying stock moves. So a large move will have a relatively tiny impact on the value of all the options, if the puts and calls come reasonably close to balancing (which they won't always, of course).
Second, options that are way out of the money, and thus only have a tiny chance of being exercised have their notional value calculated the same way that options way in the money (and thus having a nearly 100% chance of being exercised on or before expiration) are calculated.
Third, the financial clearing houses and margin rules for stock options are extremely conservative. They isolate the risk of the investor to the market -- not to the financial position of the party on the other side of the trade. They ensure there is plenty of capital to back the options, even if the market moves way against a trader. And if margin calls aren't promptly met, they ensure positions are liquidated to prevent further losses, which reduces risk.
...
So, comparing the notional value of , say, stock options on a mature, well regulated options market, to poorly regulated CDO's which have dicey capital requirements makes little sense. But just adding up the total amount of notional value of all derivatives and lumping them together as though they're all as dangerous as nuclear bombs in the hands of terrorists is doing exactly that.
I'm not disagreeing, BTW, with Buffett's descriptions of derivatives (which are poorly regulated and financially backed) as "financial weapons of mass destruction" at all.
I'm disagreeing with the general lumping of ALL derivatives into that bucket, and especially using the total notional value to try and make the pile of bombs look MANY times bigger than it truly is re true financial net risk.
So if the purpose of some website citing such numbers is FUD, along the lines of a zerohedge article, I call (mostly) nonsense. If it's to compare scale compared to, say, prior decades, that might be a valid point, but again, the underlying NATURE and size of the various types of derivatives would be critical in determining (roughly) the magnitude and probability of serious real world risk over a given time frame.
Given the track record of the perma-doomer blogs, I wouldn't bet a fast crash doomer's money on their predictions.