As the global financial crisis unfolded in October 2008, part of the Australian government’s response was to provide unlimited guarantees of bank deposits and wholesale funding. One result was that the big four banks got bigger while little was said of the $13.8 trillion in off-balance-sheet derivatives to which they were exposed.
Derivatives operate in a global over-the-counter (OTC) market that is almost totally unregulated.
Derivative trades are not listed on any exchanges, not available for public scrutiny, not subject to a clearing system and rarely appear on external balance sheets. This makes estimates of the size of the market — which, last year, had Australia’s OTC derivative market at $78 trillion compared with GDP of about $1.5 trillion — an educated guess at best.
In mid-2008, the outstanding notional amount of financial derivatives was estimated at US$684 trillion by the Bank of International Settlements.
Betting on interest rates and foreign exchange rates accounted for some US$513 trillion; credit default swaps more than US$60 trillion and collateral debt obligations and other exotic instruments over US$90 trillion. By comparison, world GDP stood at US$50 trillion.
Ian Stewart, Emeritus Professor of Mathematics at Warwick University, has described derivatives as “investments in investments, bets about bets.”
He provides an account of the Black-Scholes equation devised by the US economists Fisher Black and Myron Scholes and given extra justification by Robert Merton soon after it was formulated in 1973.
Besides winning Merton and Scholes the 1997 Nobel Prize in economics, it was said to provide a rational way to price financial contracts when they still had time to run — a process Stewart likens to .
He explains that mathematical models of reality rely on simplification and assumptions. They do not adequately represent reality.
Black-Scholes’ maths may make perfect sense to mathematicians, but in the hands of imperfect humans often operating on herd instinct in a market that is more volatile than the maths assumes, derivatives can easily come to fit Warren Buffett’s description as “financial weapons of mass destruction”.
Stewart asserts that in 2007 the international financial system was trading derivatives valued at US$1 quadrillion (1000 trillion) — 10 times the total worth (adjusted for inflation) of all global manufacturing products made in the preceding 100 years.
The US economist Robert Skidelsky describes neo-classical economics as a mathematically souped-up version of classical economics that continues to trade on the illusory belief in self-regulating markets.
In contrast to an older generation of economists who used maths to make predictions about the real world more precise, economists today employ mathematicians to create “an axiomatic system whose virtue lies in its unrealism”.
Back in the real world, Scholes and Merton became directors of the US hedge fund Long Term Capital Management (LTCM), where they put their mathematical models to work and managed to accumulate off-balance-sheet derivatives with a notional value of US$1.25 trillion.
In 1998, one year after they received the Nobel Prize, LTCM lost US$4.6 billion in less than four months. The Federal Reserve Bank of New York was forced to organise a US$3.625 billion bailout.