600,000,000,000,000?

If some banks are too big to fail, $600 trillion has become the number too big to question. That's $600,000,000,000,000—the rough figure cited in many news reports for the total size of the derivatives market, now blowing up to such alarming effect. At a time of mind-boggling turmoil on Wall Street, perhaps it's not surprising that few stop to ponder how a market for obscure financial products, or any product, could have quadrupled in size since 2002, and now measures more than 12 times the size of the world economy. How could any "market" rack up sales that dwarf the income of all nations combined? First of all, that $600 trillion figure is out of date, from the end of last year. Official figures haven't been released, but surveys reveal the market has now grown to at least $668 trillion. But the good news is that most of it is not real money. This market is at least a bit less incomprehensibly huge, and dangerous, than the 15-figure numbers suggest.

A little background: derivatives are exactly what they sound like—their worth is derived from something else. That something else could be General Motors stock or Morgan Stanley bonds or any number of other items. In a credit default swap, for instance, a hedge fund that loaned $10 million to Southwest Airlines might agree to pay 1 percent a year, or $100,000, to an investment bank. In return, the investment bank agrees to pay the hedge fund the full $10 million if Southwest goes bankrupt. When journalists print big, scary numbers like the $668 trillion figure above, they're referring to the "notional value," or the worth of the underlying assets—$10 million in the Southwest example. In almost every case, only a small sliver of that ($100,000 in this case) is real money changing hands.

"It's not a wrong number," says Stephen Figlewski, a professor of finance at NYU's Stern School of Business and founding editor of the Journal of Derivatives, of the hundreds of trillions. "But it's not at all comparable to the sort of things people are trying to compare it to, like the total amount of stock traded on the New York Stock Exchange. These numbers cannot be compared." Saying there's $668 trillion in derivatives floating out there is like saying every lottery ticket sold is worth the full value of the jackpot. If the jackpot is $100 million and lottery organizers sell 2 million tickets, "that's $200 trillion worth of lottery wealth that's circulating!" jokes Figlewski. "When you say it that way, everybody knows that's a complete nonsense number."

The total world market value of derivatives—the money these promises are actually worth today—is more in the neighborhood of $15 trillion. That is still huge, slightly larger than the U.S. economy. And it's growing fast: the derivatives market has been doubling in size every two or three years for the last decade, for many reasons. Increasingly sophisticated computers make it easier to create and price complicated derivatives. Another is the continuing rise of "quants," math geniuses who Wall Street began recruiting in the mid-1980s, precisely to invent exotic new financial products. Top universities smelled the money, and now most have graduate programs in financial engineering.

Above all, derivatives fill a need, and most are not explosive. Of the $668 trillion, most are interest-rate swaps, which, at the end of 2007, had a total notional value of $393 trillion (and a market value of $7.2 trillion). These are relatively plain-vanilla hedges against changes in interest rates, which will force a crisis only in the event of highly unlikely spikes in interest rates or inflation, experts say. The only sector of the derivatives market that is imploding are the credit default swaps—notional value, $55 trillion—which are particularly risky because they work like hurricane insurance: there's a small probability of a huge payout. That happened in September, when big firms like Lehman Bros. failed suddenly, putting a huge strain on CDS holders. These were the derivatives that Warren Buffet singled out as "financial weapons of mass destruction" in his prescient 2002 warning. He was more sanguine about other types of derivatives, and experts today don't see in them the same risks as in the CDS market.

At their core, derivatives are "insurance products," says Columbia professor Emanuel Derman, one of Wall Street's original quants. "You pay a premium and you get protection." Despite this year's setbacks, says Derman, the market for exotic derivatives, including credit default swaps, is destined to grow. "There really isn't any alternative," says Figlewski. In a few years' time, derivatives could become a quadrillion-dollar market.

With that growth comes the continued potential for a blow-up, in large part because there is no clearinghouse for trading in most kinds of derivatives. Such an institution would make trades and risk more transparent, which is why many government officials as well as experts like George Soros and Robert Reich are pushing for it. Until then, the $55 trillion question is whether controls can be put in place before the CDS market explodes, again.

© 2008