Derivatives Market Grows to $596 Trillion in a Financial Tower of Babel

Derivatives Market Grows to $596 Trillion on Hedging
By Abigail Moses


May 22 (Bloomberg) -- The market for derivatives expanded at the fastest pace in at least a decade last year as the global credit crisis spurred trading in contracts used to hedge against losses, according to the Bank for International Settlements.

Derivatives, including those based on debt, currencies, commodities, stocks and interest rates, expanded 44 percent from the previous year to $596 trillion, the Basel, Switzerland-based bank said in a report today. The amount of credit-default swaps protecting investors against losses on bonds and loans more than doubled to cover a notional $58 trillion of debt.

``The credit crisis supported growth'' of the market, Naohiko Baba, an analyst at BIS who co-wrote the report, said in an interview. ``Fixed-income markets experienced big turmoil so had more hedging needs.''

Investors turned to derivatives to bet that the $383 billion of credit losses and writedowns at banks and securities firms since the start of 2007 would push the world economy into recession. The cost of protecting corporate debt against default jumped as much as 670 percent last year, according to the Markit ITraxx Europe Crossover index. (This sounds so much like 'portfolio insurance' of the 1980's - Jesse)

The increase in the cost of credit-default swaps quadrupled the amount of money investors have at stake in the contracts to $2 trillion from $470 billion, the BIS said. The amount at risk in the entire derivatives market is $15 trillion, according to the BIS, which was formed in 1930 to monitor financial markets and regulate banks.

Price Increase

Credit-default swaps pay the buyer face value in exchange for the underlying securities or the cash equivalent should a company fail to adhere to its debt agreements. Derivatives are financial instruments derived from stocks, bonds, loans, currencies and commodities, or linked to specific events like changes in interest rates or the weather.

The data on the BIS report are based on contracts traded outside of exchanges in the over-the-counter market.

Interest-rate derivatives remained the largest part of the market, expanding 35 percent to $393 trillion outstanding last year, the report said.

Foreign exchange derivatives grew by 40 percent to $49 trillion as the credit crisis triggered the highest volatility in the seven most-traded currencies in almost eight years, based JPMorgan Chase & Co. data.

The amount of equity derivatives outstanding expanded 14 percent in 2007 to $8.5 trillion.

Commodity derivatives expanded by 26.5 percent as the price of gold and oil reached records. Contracts based on gold rose the most in the second half, by 40 percent to $595 billion. Crude oil rose to a record above $135 a barrel in New York yesterday after U.S. stockpiles unexpectedly dropped.

To contact the reporter on this story: Abigail Moses in London Amoses5@bloomberg.net

Last Updated: May 22, 2008 07:06 EDT