Awesome Statistic About Derivatives slight return

Yesterday I wrote a post entitled, “Awesome Statistic About Derivatives” and I wanted to post a few additional comments to help create a better context for understanding the information.

First, in the comments section of the blog I was asked if I could corroborate the data as reported by Mark Möbius of Templeton where he claimed that the total value (i.e. the notional value) of all over the counter derivatives contracts was ten times larger than worldwide gross domestic product.

The answer was “yes.”  The Bank for International Settlements reported that the total notional value of OTC derivatives contracts at the end of 2010 was $601 trillion.  Meanwhile, the U.S. Central Intelligence Agency World Factbook reported total worldwide 2010 gross domestic product as $61.96 trillion.  So Möbius’ claim was spot on.

While alarming, the statistic isn’t quite as alarming as it may sound.  Why?

Most importantly, gross domestic product (GDP) is a measure of financial return.  In order to generate financial return you need underlying assets.  Think about your own bank account.  In order to earn interest, you have to have principal.  GDP is the equivalent of interest.  So how can we figure out total worldwide principal?

To my knowledge no one has ever attempted to do this before.  However, I do know that over time real economic growth has averaged around 3%.  That means that through basic mathematics we can make a guess as to what the total value of assets worldwide is, like this:

$61.97 trillion 2010 GDP/return ÷ 3.0% = $2,065.7 trillion 2010 total worldwide assets

Presumably that $601 trillion of derivatives contracts is written with underlying collateral of real assets.  If so, then that $601 trillion worth of derivatives contracts represents: $601 trillion ÷ $2,065.7 trillion of total worldwide assets = 29.1% of total assets.

Clearly this number is less scary.  But I still consider it to be really scary.  Why?  Because most of the derivatives contracts that are written are not collateralized by real assets, just the credit of the issuer.  And it is still true that most derivatives traders never have any intention of taking possession of the underlying assets on their derivatives contracts.  No.  Instead, they are looking to earn money on variances in price and differences in predictions as to the price direction of the underlying assets.

The word for this is speculation.  That speculation is to the tune of 29.1% of the total value of all assets on the planet and represents almost 10 years worth of global economic return.   And that is scary.

Jason