Markets ignoring Buffett's warning about derivatives

Markets ignoring Buffett's warning about derivatives

Complacent markets are ignoring Warren Buffett's warning that the complex, massive derivative market could precipitate an unexpected global financial shock.

The Bank of International Settlements (BIS), the central banks' central bank, has also issued a warning - that the world's central banks would find it very difficult to counter the mass-selling of bonds, equities and their derivatives by panic-stricken asset managers.

The latest triennial survey of the BIS found that the daily turnover in over-the-counter (OTC) interest-rate derivatives averaged US$2.7 trillion (S$3.6 trillion) in April 2016 - up from US$2.3 trillion in 2013 and US$2.1 trillion in 2010.

Turnover this year was boosted in part by more comprehensive reporting by dealers. Even so, the increase between 2013 and 2016 would have been larger still, but for the depreciation of many currencies against the US dollar.

Dealings in these financial derivatives would swamp markets. Trading between reporting dealers and other financial institutions - smaller banks and dealers, institutional investors, hedge funds and proprietary trading firms - has been behind the bulk of the increase in the turnover of interest-rate derivatives since 2013, continuing a trend observed in previous surveys.

The US has become the largest centre in derivatives trading, surpassing the UK. The US's share of global turnover rose from 23 per cent in April 2013 to 41 per cent in April 2016; meanwhile, the UK's proportion of trade fell from 50 per cent to 39 per cent.

In the Asia-Pacific, trades moved away from Japan and Australia, especially for local-currency contracts. Volumes in Hong Kong SAR and Singapore rose substantially, the BIS said.

Warren Buffett began warning about the derivatives market 13 years ago; indeed, there were large hedge fund losses and contraction and price collapses in the crash of 2008 to 2009.

Since then, central banks have raised the bar of their "macroprudential" supervision and this has reduced the growth in trade. But despite these moves, Mr Buffett warns that derivatives could still create "dangerous" jolts in value that would exacerbate a major shock.

"Some of these things get so complicated they're very hard to evaluate... I know one that's so mismarked it would blow your mind, and I don't think the auditors are necessarily capable of holding that behaviour in check," he said.

He described derivatives as "weapons of mass destruction".

The ultimate fear is that a herd of hedge funds will be caught on the wrong side of the market. They would be forced to sell their credit derivatives and other assets to pay off borrowings. Losses will increase and other players will be caught in the downwind, and be forced to sell assets. The market will become illiquid as buyers withdraw; the chain reaction would cause a general bond and stock market collapse, hitting smaller investors and pension funds.

Private-equity funds have fuelled the upturn in global stock markets with highly leveraged deals. Some of the over-borrowed corporations resulting from these deals could fail following a surge in bond yields, that is, the long-term interest rate, causing plants to close down and workers to be laid off. The market's gloom would thus be passed on the economy.

The BIS said the notional amounts of global OTC interest rate, equity, commodity and credit-default swap derivatives fell from US$617 trillion in the first half of 2014 to US$422 trillion in the second half of last year, mainly because of much tighter regulatory supervision. The gross market value of the contracts declined from US$15.7 trillion to US$11.9 trillion.

This article was first published on September 06, 2016.
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