Derivatives’ shrinkage – a danger sign?

A DECLINE in global derivatives trading to their lowest levels since 2007, is regarded as an indication that global markets have become sanguine.

The Bank for International Settlements (BIS), the central banks’ central bank, has disclosed that the gross market value of interest rate, foreign exchange, equity and credit and commodity derivatives fell from US$15 trillion in 2016 to US$13 trillion in the first half of this year.

This is the lowest level since the end of June 2007.

Derivatives Chart

It compares with the all-time peak of US$35 trillion during the financial crisis of 2008.

Derivative trading tends to surge when the market is experiencing acutely uncertain conditions and prices are volatile. When prices are gyrating, growing numbers of traders and investors hedge positions by purchasing derivatives.

The bear market of 2008 to 2009 is a classic example of a surge in derivatives hedging as players scrambled to insure themselves against further price declines.

Higher volatility also tends to be accompanied by an increase in derivatives speculation as speculators prefer to operate in active markets.

In contrast, when market players are confident during bull markets and volatility is declining or very low, the incentive to purchase or even speculate in derivatives, wanes.

The past twelve months is an example of such a period, although last week, the VIX, an indicator of market volatility jumped off its lows, when Wall Street and other stock markets dipped from their peaks.

Several cautious fund managers and economists have warned that the low level of volatility is a warning that markets are overdue for a correction.

They fear that the bull market in both equities and fixed income securities is already eight years old and with price-earnings ratios high and bond yields at very low levels, a setback could occur at an unexpected moment.

The participants recall the global equity bull market that began to peak during 2007, another year of low volatility.

For this reason, dealers and investors have been reacting to the slightest nuances of Janet Yellen, chair of the US Federal Reserve Board and her European and Japanese counterparts.

So far, central banks have managed to keep markets relaxed by promising gradual interest rate rises.

Stock market bulls thus believe that equity prices, in particular will rise.

The worry, however, is that prolonged monetary ease and low interest rates could precipitate higher than expected inflation. In such an environment bond prices could fall and interest rates would rise. Equity markets would come under pressure.

According to Fitch Ratings, trading profits of investment banks have been dented as clients have decided that it is unnecessary to hedge positions in a period of low volatility.

Warren Buffett, has issued warnings that complex derivatives in banks’ balance sheets are a “potential time bomb” that could explode in times of stress.

© copyright Neil Behrmann

This article was first published in The Business Times, Singapore.

Jack of Diamonds Neil’s thriller on global diamond mining and smuggling, will be published in coming weeks. It is the sequel to the thriller, Trader Jack, The Story of Jack Miner. Neil is also author of anti-war children’s novel Butterfly Battle- The Story of the Great Insect War. The updated 2015 Waterloo commemoration version of Butterfly Battle is on Kindle and e-books. Book reviews are on and Amazon and more reviews are welcome. If the books are purchased direct on this site, a proportion of the proceeds will go to low cost charities.

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