Derivatives - an accident waiting to happen?

Interesting piece from Morgan Stanley analyst Serhan Cevik:

Driven by the global liquidity cycle and investors’ growing risk appetite, the notional amount of exchange-traded derivative instruments increased from US$2.3 trillion in 1990 to US$14.3 trillion in 2000 and then soared to US$84 trillion in the first half of this year. According to the Bank for International Settlements, annual turnover recorded an astounding surge from 510 million contracts to almost 7 billion contracts over the same period. However, this is still just a small part of the pool of synthetically created financial products, most of which are actually traded over the counter. Indeed, the data compiled by the International Swaps and Derivatives Association show that the outstanding volume of over-the-counter credit derivatives increased from US$3.5 trillion in 1990 to US$63 trillion in 2000 and over US$283 trillion this year. Put differently, the total amount of exchange-traded and over-the-counter structured financial instruments ballooned from 27.3% of global GDP in 1990 to 772.8% this year.

Highly leveraged positions have started turning into a futile game of musical chairs. In today’s global network of financial markets, almost everything becomes interdependent and correlated, diminishing the advantage of portfolio diversification. Take, for example, the breathtaking rise of the hedge fund industry. In 1990, there were only 300 hedge funds in business, increasing to 3,000 by the end of the decade. On the latest count, however, the number of hedge funds reached over 10,000, with approximately US$1.5 trillion worth of assets under management. Although that may still look small relative to the rest of the investment community, hedge funds employing risky derivatives strategies to enhance returns already account for 45% of emerging-market bond trading volume and 55% of all credit derivatives trading in the world. In other words, the rise of hedge funds, driven by cheap financing, is behind the explosive growth in structured products and massive flows to emerging markets. However, as the number of players searching for arbitrage opportunities has kept increasing, seeking alpha via highly leveraged positions has started turning into a futile game of musical chairs. Indeed, as competition has squeezed returns, the number of failed hedge funds increased from 4.7% of the funds in operation in 2004 to 11.4% last year.

His last point is important - the sheer number of hedge funds in existence are competing away any advantages hedge funds may have had over ordinary funds. But ordinary investors continue to pour money in, believing they can get better than average returns. It's quite possible that much of the growth in M4 since 2003 has been lending to hedge funds rather than households. Central bankers are worried. At the meeting of the G-10 central bankers on the weekend, Jean-Claude Trichet, President of the ECB said that "There is an under-pricing of risks in general in financial markets,'' and that he and his G-10 colleagues "don't exclude the possibility that there will be a re-pricing of risks,'' though the central scenario was that the process would be "`orderly, smooth and progressive.'' .