What's 10 Times Bigger Than the Global Economy?

What’s 10 times bigger than the gross world product (GWP) and getting bigger every year?

Here’s a hint: It’s a financial instrument that you’ve probably never heard of and, even if you have, most likely don’t understand.

But what you don’t know or can’t grasp can, in fact, hurt you. It can hurt all of us.

They’re called derivatives, and like so many investment vehicles today, the way they work is a mystery even to many of those working in the financial industry.

Here is a very down-to-earth explanation of what a derivative is, according to a New York Times article published last year:

A derivative is a contract between two parties whose value is determined by changes in the value of an underlying asset. Those assets could be bonds, equities, commodities or currencies. The majority of contracts are traded over the counter, where details about pricing, risk measurement and collateral, if any, are not available to the public.

Simply put, a derivative is a side bet.

A Bet Against a Bet

Like most side bets, derivatives were initially designed as a hedge against risk, but this hasn’t stopped speculators from getting into the market.

For example, a European investor purchasing shares of an American company off of an American exchange (using U.S. dollars to do so) would be exposed to exchange-rate risk while holding that stock.

To hedge this risk, the investor could purchase currency futures to lock in a specified exchange rate for the future stock sale and currency conversion back into euros.

On the surface, these contracts have no value on their own. They do not symbolize shares of a functioning company or interest-bearing vehicles like government bonds.

They merely state an agreement between two parties to trade at a future date at a set price… or some variation on that theme.

In a world where investors will bet on anything, or in this case on the performance of a previous bet, the derivative market has been blowing up steadily.

Valuing derivatives isn’t easy, but the estimates right now are that the total global derivative market is currently worth between $710 trillion and $1.2 quadrillion.

Don’t even bother trying to visualize that number. Just know that it’s between 10 and 16 times the size of global gross domestic product.

In other words, more paper value than the whole world produces in a decade.

Sounds like a bubble, right? Only how does a bubble made of intrinsically valueless paper put all of us in danger?

Meet the New Bubble… Same as the Old Bubble

As usual, it all goes back to the banks.

According to the federal government, the top 25 banks in the United States now have a grand total of more than $236 trillion of exposure to derivatives.

Just four of those institutions account for a vast majority of that figure:

JPMorgan Chase Total Assets: $1,945,467,000,000 (nearly $2 trillion)
Total Exposure to Derivatives: $70,088,625,000,000 (more than $70 trillion)
Asset-to-Derivative Ratio: 36

Citibank Total Assets: $1,346,747,000,000 (a little over $1.3 trillion)
Total Exposure to Derivatives: $62,247,698,000,000 (more than $62 trillion)
Asset-to-Derivative Ratio: 46

Bank of America Total Assets: $1,433,716,000,000 (a little over $1.4 trillion)
Total Exposure to Derivatives: $38,850,900,000,000 (over $38 trillion)
Asset-to-Derivative Ratio: 27

Goldman Sachs Total Assets: $105,616,000,000 (just over $105 billion)
Total Exposure to Derivatives: $48,611,684,000,000 (more than $48 trillion)
Asset-to-Derivative Ratio: 462

That bubble pattern should be clear from those ratios — and it’s no coincidence that some of the same massive financial institutions that took equally massive government bailouts just a few years ago are now at the nucleus of this trend…

A trend that, also by no coincidence, has been gaining momentum steadily since the last meltdown.

So long as the stock market continues to rise, as it has been… so long as interest rates stay stable and the global economy does not go back into free-fall… this bubble will continue to expand.

However, once another catalyst puts the markets into a nosedive — hints of which we already saw earlier this week when the Dow tested 1,000-point losses — a derivatives crisis could easily and rapidly cause the four major banks listed above to fail.

It Doesn’t Take an Oracle to See Where This is Headed

Failure of this severity would cascade down to every corner and every level of the economy, causing industrial and corporate collapse on levels unseen since the Great Depression.

And you don’t need to have a deep understanding of forwards, futures, mortgage-backed securities, or any of the other varieties of derivative being turned out by these major financial institutions.

Just think of it in the most basic terms I’ve described here: a side bet that’s grown to be far larger than the assets on which it’s based.

During a moment of panic, such an imbalance in value would simply have nowhere to go.

And its magnitude would crush us far worse than the collapse of the housing bubble did just a few years ago.

Compounded with all of the other problems facing the modern economy, few words describe the current state of the global economy better than “critical.”

And yet there are people out there who still base their projections of stability and future growth on things like housing prices, the DOW, or highly questionable definitions of employment.

It’s what we don’t see, don’t think about, and, in this case, don’t really understand that presents the biggest risk of all.

Don’t get caught unaware. Learn to anticipate and prepare.

Fortune favors the bold,

Alex Koyfman

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