Notional amount is not a good measure for the OTC market. It has two main problems it double (or more) counts multiple step transactions and it doesn’t net offsetting transactions.
For the first problem, the power grid is a good analogy. Imagine you wanted to assess the total amount of power in the US power grid, so you add the amount of all power leaving plants, plus the amount of everything that passes through high voltage lines, plus the amount of everything going through substations, plus the amount of everything on transformers, plus the amount of everything going through local grids, plus the amount of all power used by homes or companies.
Since power goes through all of those steps, if you count each step separately and sum, your total will be massively overstated.
Netting: if a friend and I get lunch twice and I buy the first lunch and a friend buys the second we call it even and that’s that. If two large corporations do the same thing, they leave both contracts in place. This is because wiring money back and forth is cheap and canceling or amending contracts is cumbersome and incurs legal costs ( which are expensive). So even though economic exposure is zero, notional exposure is the cost of lunch *2.
For long dated contracts that are around for years, repeated nettings can build up large meaningless notionals that bloat the figures.
Both these issues with notionals are well known, so you should probably slightly update your wariness for whatever source was quoting notionals without the requisite disclaimer.
Once you account for this and other forms of derivatives-are-hard-to-count problems, it’s down to “only” a few trillion. I;m unable to find a good estimate regarding what fraction of the “financial system” (squares quotes indicating the term is not well defined here) that is.
WQ’s response was great. I have worked in “the financial system” for nearly 20 years and just in terms of real assets under management, most of the handful of large global firms are each managing assets in the low trillions, and those are “real” assets in the sense that they aren’t really anything you could say was being counted more than once due to arcane accounting rules or contractual obligations or whatever.
Back around 2007/2008 there were a few numbers in the mid-tens-of-trillions being tossed around in the news that were guesstimates of the total global net worth, and although I forget the numbers now, I would be very surprised if the sum of assets under management was not approximately equal to those numbers. Via trusts and so on, such firms even manage physical assets (paintings, yachts, diamond rings, office buildings) to varying extents that most people don’t think about as being managed by “the financial system.”
The only place where I’d change WQ’s response is to blame regulation more than legal costs. Not that legal is cheap for these firms, but regulation and compliance is the biggest cost-factor by such a large margin that everything else is nearly irrelevant (in fact, legal costs are just a side-effect, for the most part).
As a factual mater, I don’t think this is true. Source?
Most estimates I’ve seen of notional value for OTC derivatives are in the range of $1 quadrillion.
Notional amount is not a good measure for the OTC market. It has two main problems it double (or more) counts multiple step transactions and it doesn’t net offsetting transactions.
For the first problem, the power grid is a good analogy. Imagine you wanted to assess the total amount of power in the US power grid, so you add the amount of all power leaving plants, plus the amount of everything that passes through high voltage lines, plus the amount of everything going through substations, plus the amount of everything on transformers, plus the amount of everything going through local grids, plus the amount of all power used by homes or companies.
Since power goes through all of those steps, if you count each step separately and sum, your total will be massively overstated.
Netting: if a friend and I get lunch twice and I buy the first lunch and a friend buys the second we call it even and that’s that. If two large corporations do the same thing, they leave both contracts in place. This is because wiring money back and forth is cheap and canceling or amending contracts is cumbersome and incurs legal costs ( which are expensive). So even though economic exposure is zero, notional exposure is the cost of lunch *2.
For long dated contracts that are around for years, repeated nettings can build up large meaningless notionals that bloat the figures.
Both these issues with notionals are well known, so you should probably slightly update your wariness for whatever source was quoting notionals without the requisite disclaimer.
Once you account for this and other forms of derivatives-are-hard-to-count problems, it’s down to “only” a few trillion. I;m unable to find a good estimate regarding what fraction of the “financial system” (squares quotes indicating the term is not well defined here) that is.
WQ’s response was great. I have worked in “the financial system” for nearly 20 years and just in terms of real assets under management, most of the handful of large global firms are each managing assets in the low trillions, and those are “real” assets in the sense that they aren’t really anything you could say was being counted more than once due to arcane accounting rules or contractual obligations or whatever.
Back around 2007/2008 there were a few numbers in the mid-tens-of-trillions being tossed around in the news that were guesstimates of the total global net worth, and although I forget the numbers now, I would be very surprised if the sum of assets under management was not approximately equal to those numbers. Via trusts and so on, such firms even manage physical assets (paintings, yachts, diamond rings, office buildings) to varying extents that most people don’t think about as being managed by “the financial system.”
The only place where I’d change WQ’s response is to blame regulation more than legal costs. Not that legal is cheap for these firms, but regulation and compliance is the biggest cost-factor by such a large margin that everything else is nearly irrelevant (in fact, legal costs are just a side-effect, for the most part).