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Actually, a better question is, “Who were the losers?”  I’ve written several times that the derivatives market is a zero sum game where for every winner there is a loser and that when volatility or a sustained move sets in, “winners” will become “losers” because the loser cannot pay up.  I’ve had a few e-mails telling me that I’m wrong and take a too simplistic view of this, that I “just don’t get it.”  Maybe so but I don’t think so.

The total derivatives market is over $1 quadrillion. This completely dwarfs the size of all markets combined.  When you add up all of the stock markets, bond markets, commodities markets and real estate (plus money supplies) you still fall short of $1 quadrillion.  If ever there was a place or “picture” of the tail wagging the dog itself it is here in the derivatives market.

That said, logic would tell you that there are also greater “gains and losses” behind the dark curtain called the derivatives market.  But, we just don’t hear about them.  We heard a few chirps back in 2008 when Lehman Bros. went down the “chain” would break but very little since then.  In fact, the “chain” did break but it broke behind the curtain and banks just did not report on this.  Since these derivatives are largely not marked to market and thus don’t require huge margin calls they are carried on each firms books at prices that are simply made up.  “Mark to fantasy” if you will and this is the reason that the same contract can be carried on the books at a “gain” by both counterparties at the same time.

It is important to understand that these derivatives are mostly said to be used as “insurance.”  Against insurance rates going up and rates going down.  They are used to “insure” against movements in copper prices, oil prices, stock prices, bond prices, real estate, mortgages and even the weather …you name it…the contract can be created for whatever and they have.  But, if the “contracts” outstanding aggregate to be more than the underlying product then how real, how useful, how “truthful” can they really be?

Here is the thing; maybe these were originally created by some Dr. Frankenstein with good intentions to be used to “hedge.”  What they finally morphed into were “bookkeeping” entries that for pennies on a $100 bill were bought (or sold never expecting to pay) as “protection” so that the institution could lever up their balance sheet 50 or 100 times over and still say with a straight face that they are “protected” and have “laid off risk.”

The theory went that risk could be “laid off” throughout the entire system so that ANY event would have its risk spread around and no 1 single institution would fail.  It worked…for a while…until “they let” Lehman go under which unleashed the “daisy chain” scenario.  What happened afterwards? It scared the crap out of those who run the show because they then realized in real time how big the monster was that they had created.

Now, the “monster” is even bigger.  The amount of unencumbered collateral left to lever up against is diminished greatly at the same time the need to reflate never greater.  The “monster” is now greater than its “master” and not only can it no longer be managed but threatens the master himself.  Now, the derivatives market itself is more likely to tank the entire system than any other event or entity in my opinion.

The only way to have kept it in its cage all this time was by false reporting.  You cannot tell me that the world is so “perfectly hedged” and a rise in interest rates of 50% in one month did not turn someone…somewhere…INSOLVENT!  Call me paranoid, call me a conspiracy nut, call me crazy…someone, somewhere lost trillions of dollars over the last 45 days based on interest rates alone yet we hear nothing.  I guess everyone…everywhere are as good as JP Morgan and Goldman traders and never ever have a losing day?  Please remember, the real world is run by computers which are programmed by “human logic”…FAULTY human logic I might add and let’s call them “unintended consequences”… they do happen.

As for my title “And the winner is?”… Can you guess?  The winner is the one who holds real assets, unencumbered and without custodians between them and their assets.  WOW, what a novel idea!