Chet -- You seem to have an obsession with derivatives, interjecting meretricious rants on derivatives into various threads...kind of like Trump tweets. Most people in any case probably don’t give a shit or have little idea of what derivatives are, except that they probably perceive them negatively based on the role a small segment of the derivatives, the Credit Default Swaps, played in the Great Recession.
I don't know what your purpose is in continually bringing them up, and I certainly admit to not understanding your logic. Maybe your whole purpose is to bait me into a discussion. Okay, for one more time I will share my understanding of derivatives. I spent quite a bit of time trying to understand them years ago, but decided it's not worth my time.
First, for those who might be even slightly interested, a derivative is a financial contract whose value is based on, or "derived" from, a traditional security such as stocks and bonds, mortgages, assets such commodities or market place indices. There are thousands of different types of derivative contracts traded daily on global financial and commodities markets; they can be grouped into four basic categories: futures contracts, forward contracts, option contracts and swaps. They serve an important need for the business community with over 94 percent of the 500 world’s largest companies using them to manage cost variability and other risks in their worldwide business operations.
One of the obvious advantages of derivatives is that businesses do not have to maintain large cash reserve accounts for potential downside risks in the markets. Having transferred that risk to companies or individuals that specialize in risk management means that they have more capital to invest in other opportunities that create jobs. Furthermore, derivatives act to stabilize volatility in segments of the market.
The sellers of derivative contracts are "hedgers". In the commodities markets they include businesses that produce, ship, process or otherwise handle the products – oil and gas producers, refiners, mining companies, grain millers or individuals like farmers that cannot afford the volatility in markets and want to lock in future prices or interest rates or currency rates for future stability in their businesses. In the financial derivatives markets, the players are banks, investment firms, mortgage lenders, insurance companies, hedge funds, currency traders and governments.
The risk decisions that sellers make are not unlike those of the average homebuyer is faced when evaluating a fixed 15 or 30-year fixed rate mortgage versus an adjustable rate mortgage. They are hedging. Derivative trading, like decisions on home mortgages, then is essentially buying an insurance policy against possible future adverse market conditions. Derivative contracts, “insurance policies”, are sold and resold in the market place as interest rates or other market factors such as foreign currency exchange rates continually change. The higher the market volatility, the more they are sold or traded in the global market place. Longer term futures contracts and options help tamp down volatility.
The buyers of derivatives are the “speculators” – professional money managers, financial engineers, and highly-experienced investors including banks and hedge fund managers who make it their business to understand risk in certain markets. They perform a valued need to the businesses who do not have expertise in the matter but need more stability in prices, interest rates, and currency rates to provide assurances to their stakeholders. And in return they take a share of the profits as compensation for taking the risk that the business could not afford.
The ease with which players can enter the market has also given rise to many small-time gamblers – those lacking the expertise in the specialized markets but are attracted by the potential of big gains through margin trading. Many of them end up losers. The professionals try discourage the gamblers from trading in the market by pointing to the immense risk.
There have also been highly knowledgeable but less scrupulous players primarily in the over-the-counter derivatives market engaging in fraudulent activity driven by greed. The Bernie Madoff Ponzi scheme is just one example of bad actors who were largely able to conduct their illicit activities because of the lack of oversight or incompetence by regulatory agencies in the over-the-counter derivatives market.
You have often quoted a $1.2 quadrillion figure as the size of the derivatives market. That number is not a product of conventional arithmetic like the Dow Jones Index, but rather the high-end of a range of estimates based on complex mathematical models. Dr. Paul Wilmott, a mathematics professor at Oxford University who makes money selling books on the subject has been attributed as the source, but I could not find any specific references in his books and articles to the $1.2 quadrillion figure. Nevertheless, that number is bandied about in the blogosphere taking on a populist kind of “shock and awe” cause by critics of the derivatives market. Other sources put the number closer to $700 trillion.
Nevertheless, one needs to understand that the estimate is based on “notional values”. The notional value, or more accurately the notional principal value, in derivative contracts is not a real value because the principal in the derivative contracts never changes hands.
For example, there is a good chance your house mortgage is being traded in the derivatives market, but the buyers and sellers of your mortgage are not buying and selling your house -- only the mortgage. And the notional value of a 30-year mortgage with interest can be quite high with the interest payments exceeding the original principal. Factor in the millions of house mortgage contracts traded daily in the swaps market, or the value of millions of bushels of grains, or the millions of barrels of crude oil traded, or millions of ounces of precious metals as well as interest and currency swaps and one can certainly visualize how the notional value number can aggregate in size…in the hundreds of trillions of dollars if not the quadrillions of dollars estimated with mathematical models.
The Bank for International Settlements (BIS) based in Switzerland compiles statistics on the gross market value (rather than notional value) of global the over-the-counter (OTC) market. They estimate the gross market value of the OTC global derivatives at $11 trillion at the end of 2017. This is a decline from $15 trillion at the end of 2016 and $35 trillion from its peak in the second half of 2008 reflecting the reduced market volatility, primarily in interest rates. The BIS does not compile statistics for equity, commodity or credit derivatives contracts commonly traded in the exchanges
In any case, there are no available statistics in the exchange traded derivatives markets that are comparable to gross market values as calculated in the OTC markets. That is because exchange traded derivatives, i.e., futures markets, are commonly marked-to-market on a daily basis. Any losses or profits are adjusted daily, and hence there are no “unrealized profits or losses” in the exchange futures markets to report.
Therefore, only notional values can be used to compare the relative sizes of the exchange and OTC markets. The analysis is further complicated because the exchanges regularly report volumes (number of trades) as opposed to monetary values. To get a more meaningful comparison, the volume numbers need to be converted to value numbers by applying average costs. On that note, the Chicago Mercantile Exchange report of 2014 using BIS data put the notional value of the global derivatives market in 2013 at $710.2 trillion. The exchange traded part of that total was calculated at $64.6 trillion or 9 percent of the total notional values of global derivatives. I could not find updated numbers for 2017.
In summary, the notional value serves a purpose in comparing trends or the relative sizes of the markets but it has no relation to the amounts of money changing hands daily on the exchanges or over-the-market. Suggesting that there are "quadrillions of dollars" being gambled by big time "people in power" gamblers in the derivatives market earns you four Pinocchios, kind of like Alexandria Ocasio-Cortez's tweet that the Pentagon could not trace, document, or explain $21 trillion in Pentagon spending. That earned her four Pinocchios as well.
Chet there are lots of websites with tutorials on how the derivatives markets works. I would suggest you spend some time understanding derivatives before ranting about them again.