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A while back I posted this question about the possible risks of banks having massive derivatives exposures.

The most upvoted answer (by BKay) said that there was little risk because banks mainly hold pairs of opposite bets. So for example it may simultaneously hold bets with two companies (A and B) where, if the price of oil goes up sharply then it has to pay out to A, but B has to pay the bank.

So this is all fine so long as both A and B are solvent after the oil price rise. Presumably if B goes bust then the bank is still liable to A.

So now my question is - couldn't there be some scenario where there is a sudden economic shock which simultaneously means that the banks will have to do a lot of paying out of bets but where the companies that are losing bets, and owe the banks money, go bust. With such enormous exposures it wouldn't take much of a fraction of the bet-losing companies going bust to cause an enormous loss for the banks.

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Financial intermediaries handle this issue with a few tools:

  1. Collateral and margin requirements: When you sell a derivative to a intermediary you are required to post assets, in a quantity related to the size of the position and the risk of a large move in the derivative's value, in order to ensure that you are will be able to pay when required.
  2. Credit risk management: Management at intermediaries sets limits on how much derivative business can be done with an individual firm, related to its capacity to bear losses from capital and additional borrowing capacity. This limit the losses from an individual counter-parties.
  3. Central counterparty clearing house (CCP) and novation: CCPs can provide additional capital to make good on claims even if the counter party fails to do so. Central clearing can also make sure that situations like those where A fails to pay B, who then fails to pay C, who then fails to pay A do no occur. So it can eliminate a lot of senseless defaults that generate real costs and collateral changing hands to not good purpose
  4. Hedging: When a derivative has substantial jump risk and that jump risk is difficult to measure it may be costly or difficult to have the right amount of collateral. In that case it may superior to just use other financial instruments to insure against the jump directly through position risk management (hedging).
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Its possible, but, in principle, most non-financial companies use derivatives to "hedge risk", rather than to "bet". Hedging risk means that the firm will use derivatives to lower its chances of going bankrupt, for example an oil company will buy a put option on its oil output, so that if the price of oil falls after the firm invested in producing it, the firm can still sell the oil at a high price, and avoid bankruptcy. Other times, the bank is an intermediary in futures. futures allow a firm to sell its output forward in time, and another firm to buy the output forward in time. this reduces the risk for both of the firms. Of course, selling or buying forward reduces the chance of making it big if the prices improve in your favor.

Also, financial regulation forces banks to consider multiple possible future scenarios and their effects on their balance sheet. These exercises result in a measure of the riskiness of the bank, and in turn let authorities ask the bank to hold more capital or unwind some of its positions if has too much risk of some sort. The exercises include dramatic swings in commodity prices, unemployment, or the failure of large corporations, or large financial counter-parties.

There are certainly some financial agents out there that hold tons of risk. They might be indeed betting on one view or another, but because of the regulatory environment, these can't be "banks". This is very important, because if they are not banks, then their collapse does not then create contagion. A big investor looses his money, but if its not a deposit taking, (or similarly, a highly leveraged institution), then the losses, or gains, are in sense expected.

Therefore, although you are right in principle when you say that if banks stand in the middle between two firms and one of them goes bankrupt then the bank gets hit, regulation is meant to push banks away from risk. Also, the possible losses to the banks owners move them towards avoiding risk. And "risk" here includes the one that comes from their clients on one leg or another of a deal collapsing...

Here's a more detailed analysis: Congressional Research Service article on Financial Regulation. You could also do worse than by taking Nobel Prize winner Bob Shiller's online course.

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The answers above focus on how to mitigate the 'counterparty risk' that you correctly see as inherent in derivatives. But we need to also consider how big the losses can be -- the 'tons' you refer to -- and this is where the most common misunderstanding arises. The 'notional' amounts do not constitute the credit exposures and, depending on the type of derivative, either cannot be (eg, interest rate swaps) or are in practice heavily mitigated (credit derivatives).

In an interest rate swap with a notional of, say, \$100 million, all that changes hands in the related periodic payments is a fraction of that -- to be precise the difference between a fixed amount of interest on that \$100m and 'floating' rate of interest that is periodically calculated by reference to a market benchmark such as Libor. (Hence some of the concerns about manipulating Libor.) One needs to specify a notional amount, in order to have a basis for calculating those interest payments. The swap can then be used as a bet on rates or as a hedge (say of a bond position that is itself truly \$100m in size). The 'mark-to-market' (MtM) value of the swap at any given time is the expected difference, over the remaining life of the swap (which typically runs for 5-10 years), and that MtM is the amount I would be concerned about in the event that my counterparty goes bust. If the prospective difference between fixed and floating rates is in my favour, then that is the amount that I would ask for today in collateral. The Bank for International Settlements (the BIS, in its regular semi-annual statistics on OTC derivatives) has warned against looking at the notional as though it was the exposure.

Now, in the case of credit derivatives, if I sell you \$50 million of protection on, say, Deutsche Bank, there is indeed a possibility that I will (if Deutsche actually defaults) have to pay out that notional and you will in effect be taking a view on my ability to do so, as well as on Deutsche's creditworthiness. (So, if Deutsche and I were related entities, the 'joint-default' risk to you would be higher.) However, one still needs to be a little cautious on the numbers. For one thing, defaults rarely come entirely out of the blue -- the collapse of Lehman Bros, for example, was heavily trailed -- giving time to get in collateral or hedge or even close out or the contract at its mark-to-market value (essentially, the difference between Deutsche's creditworthiness when we entered the contract and its creditworthiness today). For the exposure to be systemic, which is where your query goes, that \$50 million (less any collateral) has to be life threatening to you and by extension to those whom you owe money. With the notable exception of AIG, whose regulator tellingly was later dissolved (in 2011 -- see wiki for more details) net exposures were not large. Net exposures arise where I sell you \$50m of protection on Deutsche but buy maybe \$40m worth from someone else. Check out DTCC for stats on the ratio of net to gross sales of protection. The last time I looked, net exposures were about 10% of the gross. Of course, if the $40m hedge I buy does not perform because that counterparty goes bust, then I am still on the hook for the full \$50m. But, aside from diversifying my counterparties, so that I am not overly-reliant on any one protection seller, I as a regulated entity have ways to manage the counterparty risk (more on this below); banks have regulatory limits on how much they can rely on the creditworthiness of any one entity; and have to hold capital against such credit risks as they do incur, including on derivatives.

Don't forget also, that credit derivatives are mainly focused on the more creditworthy entities and that even AIG's book was fine except for the bit linked to US mortgage repayments --from memory, about 15% of its book contributed 90% of its losses, compounded by other bets on US property. So, you do have to have some regard for the underlying risk.

Finally, bear in mind that even if 1) I do go bust owing you the full \$50m on that credit derivative on Deutsche and 2) the contract is not centrally cleared (which would insulate either of us from the default of the other) -- even in those circumstances, I would be obliged (not just able, but obliged) to take into account the \$50m I owed you on the credit derivative in claiming from you any amounts that you might owe me on any other derivatives that you and I had entered, whether credit derivatives on other entities or derivatives on interest rates, equities, currencies, commodities or any other asset class you care to imagine. In other words, the mark-to-market on an interest rate swap between us could offset that on the credit derivative. That may not sound much of an offset, given what I said above about the quantum of exposures on interest rate swaps. But again, check the BIS statistics. They show a big difference in practice between a) gross mark-to-market values and b) net ones that take account of counterparty exposures across bilateral derivatives books as a whole. If the 'gross market value' (ie, actual, mark-to-market exposures between pairs of counterparties, in aggregate, globally) is in the order of \$15 trillion, the 'gross credit exposures' (which is what the BIS calls the numbers after netting of mark-to-market exposures, taking account of offsets such as our hypothetical credit derivative and interest rate swap) is around $3 trillion. So it is roughly 1/5 of the gross mark-to-market values and considerably less than 1/100 of the notional amounts, which are around \$500 tr. So that is \$3tr of exposures, and that NB is before taking into account any collateral, which in bilateral books is calculated on a portfolio basis.

\$3tr is still a bigger amount than you or I could ever carry around in pocket money. But it's also 1/20 of the amount of government debt outstanding today and a fraction of the size of most other markets -- corporate bonds, loans, equity markets. The \$3tr could change, as things like interest rates change (thereby affecting the mark-to-market value of individual swaps), but in practice does not fluctuate wildly (as the BIS time series shows) and that is because a huge chunk of the market consists of intermediary banks buying and selling risks from customers with opposing needs or views -- risks that cancel each other out.

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In addition to Fix. B's answers and in the answers to your earlier question, there are some other risk management techniques that banks do apply, like settlement-processes (mark-to-market), in which the they daily gains and lossess on each party are credited and charged. Compare, e.g., how forward and future contracts work. On future market there are clearinghouses that quarantee the performance of the both parties. And the contracts are standardized meaning that, in general, they are better understood than the non-standard ones.

However, if you consider the sub-prime crises and AIG and the products that were used, you can make a conclusion that disasters can happen. There you had complex not-so-well understood ("hidden") derivatives that were sold to parties that knew nothing about the products and their properties. Some people suspect that some of products were used consciously to get rid or at least hide some of the obvious risks that were taken on the basic money lending. After those events, the regulators around the globe have tightened the regulation and monitoring of the entities that use derivatives, leading to less risks in general (and some people say they tightened so much that some of the viable uses of certain classes of derivates have became difficult or even impossible).

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The real issue remains one of perception, I believe. As long as enough people believe (however wrongly) that the notional numbers are amounts that must change hands, then markets will get spooked by them when other things -- impending regulatory fines, for example -- threaten an institution.

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