[FoRK] $30B a bargain for what it looks set to achieve?

[Jeff Bone]

On Mar 19, 2008, at 9:20 AM, Jeff Bone wrote:

>
> On Mar 19, 2008, at 1:06 AM, Adam L Beberg wrote:
>
>> Jeff Bone wrote on 3/18/2008 7:46 PM:
>>> Tangent:  billion is the new million.
>>> PS, Beberg --- doesn't look as though Road Warrior's actually  
>>> going to go down on this one. ;-)
>>
>> No worries, we have another 500+ Trillion to go :)
>
> Ooh, big scary number.  Do you know what that number represents?   
> Can you source it?
>
> (Serious question.  If you're referencing what I think you're  
> referencing, I might have a relevant point to make.)

I'll just go ahead and make it.  Usually when these enormous numbers  
are tossed out there they are somebody's estimate of the total  
notional value of the entire global derivatives market.  This isn't a  
measure of liquidity needed to settle all those trades --- that number  
is certainly  several orders of magnitude lower than notional value.

How's that?

"Notional value" is like the absolute value of a set of trades.  Using  
spot currency (which I'm more familiar with than e.g. options or  
future contracts) as an example, if I buy 1M EURUSD at $1.568 and  
later sell 1M EURUSD at $1.578, the "notional value" of those two  
trades from my perspective is 2M Euros, but the net open position is  
+1M + -1M = 0 Euros, with only a minimal (given the way the system is  
structured) risk should a counterparty fail to settle;  the amount I  
expect to pay or receive at settlement (i.e., the necessary liquidity)  
is *only* the size of the position times the difference in the prices,  
or 1,000,000 x $0.01 = $10,000.  Further if a third party attempting  
to quantify the "amount of trading" going on is not careful, he might  
conclude that there was 4M Euro worth of notional trading going on  
through "double counting" --- considering both sides of each trade  
independently.

Note too that the reason such apparently "ridiculous" amounts of  
leverage vs. capital on deposit are provided for folks to trade in  
these things is simply this:  the notional amounts are not a good  
gauge of risk.  Net open position value and volatility together can be  
used to construct a much better measure of risk.

This shift in value of a position over its tenor is called "mark-to- 
market" value and, at settlement, produces profits (potentially  
negative profits, called "losses." ;-)  The total liquidity necessary  
in the system to settle / accommodate all mark-to-market is therefore  
tied to the volatility or shift in the prices of the underlying  
instruments, and is not equal to the total notional value of all those  
trades;  they largely offset, or "net out" to a much smaller figure.

Further, in the true derivatives markets there are a bewildering array  
of different tenors, or timeframes of various instruments.  Many  
trades are actually constructed as multi-leg hedges to mitigate risk  
in complicated ways by offsetting trades of different tenors.  This  
again results in a (very) high number for the total notional value of  
all the trades in question, particularly relative to the expected flow  
of value at settlement.

So how much liquidity *is* needed to settle the entire outstanding  
global derivatives market?  It's impossible to know, since there's not  
complete visibility to all the multi-leg multi-trade complex trades  
out there, and the relationships between these derivatives and their  
underlying prices are complicated.  There's probably a Nobel prize in  
economics out there for somebody who builds a reasonable model of all  
this.  (The last folks to try to nail down a significant part of that  
--- Merton, Black, and Scholes --- got a Nobel for ripping off Navier- 
Stokes from fluid dynamics, and then proceeded to do an empirical dry  
run of the present circumstance in a laboratory called Long Term  
Capital Management. ;-)

At the end of the day, as long as there's electricity and food and  
water, telecom and office buildings in Manhattan, London, Hong Kong,  
and Tokyo the game's just going to keep going.  The vested interests  
can't afford to let the whole thing fail.  There's a kind of  
homeostasis in the system at large;  occasional intervention like we  
saw over the weekend may be necessary to restore it, but a living  
organism is a much better analogy for the global economy than, say, a  
trail of dominoes or a nuclear chain reaction.  The question is  
whether the present situation is more like a nasty cold or a scorching  
case of Ebola. :-/  My bet's that the situation's closer to the former  
than the latter...  so far.  If everybody universally and  
simultaneously loses confidence in the game --- then we've got  
problems, because the whole thing at some level is built on confidence.

The market seems to have reacted in a healthy way over the last few  
days.

But then, I'm not an economist --- I just play with money. ;-)

$0.02,

jb