Derivatives market grows by a quarter in just six months

By Gillian Tett
The Australian, Sydney
Monday, November 20, 2006

http://www.theaustralian.news.com.au/story/0,20867,20785202-36375,00.html

The global derivatives market surged by almost a quarter to $US370 trillion in the first half of this year as bankers, investors, and companies turned to these complex instruments to manage their risks or place speculative bets on markets.

At the end of June, the face value of all outstanding derivatives contracts in the global over-the-counter (OTC) market had risen 24 percent or $70,000 billion, according to the Bank for International Settlements in Basel. The latest figures mean the derivatives world has almost quadrupled in size since the start of the decade, with a face value on its contracts 30 times the size of the US economy.

But the BIS, which acts as a meeting forum for central banks, stressed that the data did not mean that the level of risk-taking by investors was rising at the same pace. If the value of derivatives contracts are netted off against each other, then their so-called "market risk" is only 3 percent higher at $US10 trillion -- roughly equivalent to the size of the US economy.

Nevertheless, the explosion in the headline value of derivatives contacts shows how these instruments are now playing a dominant role in the financial sphere -- even though many of these products barely existed two decades ago.

This is creating new challenges for regulators, investors, and bankers -- particularly because most derivatives activity is now occurring in the opaque OTC sector, or in private deals arranged between banks, and partly out of the control of regulators.

Data from the BIS showed, for example, that there are now four times more outstanding contracts in the OTC sphere than on regulated exchanges. This rapid pace of growth is welcomed by many investment bankers -- particularly because it is providing a lucrative source of revenues for the financial industry.

"Derivatives are a power for the good of the financial system as a whole," argues Robert Pickel, head of the International Swaps and Derivatives Association, the main industry body.

"Not only do they help individual businesses better adapt their risk profiles but they benefit the financial system by disaggregating risk more broadly."

However, the trend leaves some mainstream investors uneasy, given that derivatives can also sometimes create losses: Warren Buffett, for example, has famously dubbed them "financial weapons of mass destruction".

The largest single factor behind this year's increase was a rise in contracts that bet on the direction of interest rates. The nominal value of these grew 24 percent between January and June to stand at about $US262 trillion.

Foreign exchange derivatives also saw strong growth of 22 percent, to stand at $US38 trillion. Meanwhile, the credit default sector -- the main branch of credit derivatives -- reported 45 percent growth.

One factor behind the growth is that many traditional pension funds and other mainstream investment groups are starting to use derivatives for the first time.

However, the recent climate of ultra low interest rates is also forcing investors to embrace creative new strategies to earn returns.

Meanwhile, the new generation of computer technology is making it easier and cheaper for banks to invent new derivatives products.

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