March 6, 2012 – Financial “Weapons of Mass Destruction” Or the $700 Trillion Dollar Elephant in the Room: Big numbers can be scary, especially when it comes to $700 trillion in derivatives. At least, though, some financial firms are trying to whittle down that ginormous figure.
As of early February, financial players have torn up $184 trillion of interest-rate swaps, according to a recent announcement by the International Derivatives and Swaps Association, TriOptima, a provider of post-trade infrastructure and LCH SwapClear, an interest-rate clearing house.
And, thankfully, the sums involved aren’t necessarily as threatening as they sound. That’s because the vast majority of these transactions consist of interest-rate swaps. In these, two parties agree to exchange the cash flows associated with interest-rate payments on debt. This allows one investor, for example, to swap a fixed-rate of exchange for a floating rate.
For a definition of credit default swaps go here:
For a definition of Greece and credit defaults swaps plus a video go here:
So what’s really at risk is the money being paid as interest, not the debt underlying those payments. This means the actual amount at risk is a small fraction of the headline figure, typically in only the billions of dollars rather than trillions.
Even so, housecleaning is needed, and possible, because swaps contracts often offset each other, and their number spirals as investors open a new contract to close out an old one. Estimates are that the industry could tear up an additional $138 trillion of swaps.
This would be in addition to similar efforts in the market for credit-default swaps, which are effectively insurance on corporate debt. For those instruments, the headline amount is actually at risk, not just a portion of it. Amounts outstanding in that market have been reduced by 75% since the days of the financial crisis.
Such “trade compression” as it’s called won’t eliminate the risk posed by derivatives, famously described as weapons of mass destruction by Warren Buffet. But the moves will hopefully reduce some market clutter and give regulators a clearer view into derivatives-laden firms. And, if nothing else, there will be a few less of those weapons pointed at markets. (Credits: Picture – Getty Images, Narrative Martin Gonzalez for the Wall Street Journal).
The Master of Disaster