There are two kinds of derivatives
Over-the-counter (OTC, or direct buyer-to-seller) derivatives are contracts that are traded and privately negotiated between two parties. All OTC derivatives are unregulated, so the counterparty risk is the key factor: basically, when the contract terminates will one party stay solvent and reimburse the other without going bankrupt? According to the BIS, the total outstanding notional amount is $684 trillion as of June 2008. Of this total notional amount, 67% are interest rate contracts, 8% are credit default swaps (CDS), 9% are foreign currency exchange contracts, 2% are commodity contracts, 1% are equity contracts, and 13% are other assorted types.
Exchange-traded derivatives (ETD) are those derivatives products that are traded on regulated exchanges or markets. The exchange acts as a public intermediary for all transactions, and takes on the counterparty risk for a fee. As such, the exchanges pay close attention to all party's solvency, so party defaults are less likely than on OTC derivatives. According to the BIS (pg 108/116), the total outstanding notional amount is $77 trillion (as of June 2008.)
And now the reason for Buffet's concern becomes clear. As the world's reserve currency, the majority of all derivatives are transacted in dollars. And these trillions of dollars of worthless fiat electrons truly dwarf the rest of the world. I can show you and I bet I do not even need a graph!!
- ~8 Trillion Total Monetary Supply of US Dollars, cash, coin, and banking accounts <$100K (Federal Reserve M2)
- 15 Trillion Total US 2008 GDP, or the market value of all goods and services by all American parties
- 50 Trillion Total world GDP in 2008 per US Global
- 75 Trillion Total value of the world's Real Estate per US Global
- 77 Trillion Total nominal value of world's ETD derivatives per BIS
- 100 Trillion Total value of the world's stock AND bond markets per US Global
- 684 Trillion Total nominal value of world's OTC derivatives per BIS
[See slides 4-9 of this August 2008 presentation from US Global Investors]
So the key is that due to their massive size and inherent risk, derivatives (primarily OTC), have the potential to deliver truly staggering losses that could ripple through the rest of the financial system like a bullet train with no brakes down the slope of Mount Everest.
I think the basic trouble behind modern-day derivatives can be summed up rather succinctly. Many of today's derivatives are wagering on paper "assets" that have no intrinsic value. To wager on freely traded tangibles like corn or wheat on a commodities exchange with counterparty risk protection is one thing. To wager on paper "assets" like interest rates of a GE bond, a Fannie Mae mortgage, or the fiat Australian dollar without counterparty protection from fraudulent balance sheets, themselves consisting of fiat electrons, is pure madness.
Why and how did the mess get this big? Super briefly, Alan Greenspan of the FED decided to not regulate OTC derivatives 10 years ago. Following this decision, they mushroomed. My personal root cause analysis is that many of the traders doing the deals have no idea what makes money money, nor did they 100% understand what they were transacting, and were lured by the "miracle" of leverage and the siren song of "risk-free" profits, a complete misnomer.__________________________