Guest Post: The OTC Derivative “Nightmare” Fizzles

Via Kevin Muir of “The Macro Tourist” fame

There’s no denying OTC derivatives expanded at a frightening pace during the first decade of the new century. From a little more than $100 trillion in 2000, the total notional amount of OTC derivatives outstanding spiked to over $600 trillion by 2007.

Here is a chart from the Bank of International Settlements (B.I.S.) that demonstrates the meteoric rise.

Yup, that’s scary exponential growth. And it was definitely a contributing factor to the Great Financial Crisis of 2008/9.

These OTC derivatives were a monster headache for the street. Banks didn’t trust each other, and it was difficult for clients to offset netting trades.

Once the crisis subsided, and with the benefit of hindsight, a consensus emerged that the OTC market was a weak point of the financial system.

Therefore, when OTC derivative growth resumed in 2010, market pundits were quick to ring the alarm bell.

Here is the same B.I.S. total notional derivatives outstanding chart with the date extended out to 2015.

All sorts of dire predictions quickly filled the financial airwaves.

And lest you think I am cherry picking doomsayer type pundits, here is one from a man not known for hyperbole.

We’ll leave alone the hypocrisy of Buffett issuing this warning while he sits on the largest OTC naked put writing position in the history of modern finance.

I am by no means an unapologetic advocate of OTC derivatives. I know all too well the abuses (from both the client and dealer side) that these contracts can bring. But at the same time, I acknowledge they play an important role in our financial system.

In and of itself, OTC derivatives are not nefarious. It is therefore amusing when market pundits get all bent of out shape about the risks in the OTC derivatives market.

Human beings always focus on the last crisis. The Great Financial Crisis was scary, and OTC derivatives made it all the more frightening. Yet, do you really think Dimon and Blankfein didn’t learn from that lesson? Not a chance. I don’t know much, but I do know the next crisis will look nothing like the last.

And the funniest part of this story? Don’t look now, but OTC derivative notional amount has actually been falling for the past couple of years.

We just hit new ten year lows. Strange how all of those shrill predictions about the coming OTC derivative crisis have gone silent.

I don’t have any great insight about this development, but a simple reminder that the risks of which the pundits are screaming the loudest, are probably the ones you need to worry about the least.