It's Time To Stop Being Scared By Derivatives' Trillion Dollar Notional Values

The notional amount of derivatives held by U.S. commercial banks totaled $203.5 trillion dollars as of the second quarter of 2009 according to the latest report by The Office of the Comptroller of the Currency (OCC)

This is clearly a huge number, much larger than economic values we generally think about, but is it something to be scared about?

Felix Salmon: Oh, and did I mention? The amounts here are in trillions.

When the OCC tells us that total derivative notionals are now above $200 trillion, we can’t really help but go blank: the number is so many orders of magnitude divorced from any conceivable reality that it’s almost impossible to work out what it could possibly mean. But clearly that kind of exposure wasn’t necessary a few years ago. So why is it now?

It is surely hard to conceive of what $200 trillion is, but actually, the $203.5 trillion value it is not necessarily something to be fearful of. This is because for most derivatives the notional amount does not represent the amount of money at risk.

OCC: The notional amount of a derivative contract is a reference amount from which contractual payments will be derived, but it is generally not an amount at risk.

This can be explained by an example. Interest rate derivatives make up $171.9 trillion out of the total 203.5 trillion notional amount reported by the OCC, shown below.

OCC Derivatives

A common interest rate derivative is a basic interest rate swap whereby one company agrees to pay a fixed interest rate, while another pays a floating interest rate.

Thus imagine two companies enter into a $100 million interest rate swap for 10 years, with an annual payment frequency. Company A agrees to pay a fixed 5% interest rate every year, the Company B agrees to pay a floating interest rate based on LIBOR.

What then happens is that every year, the two parties simply calculate how much interest each owes the other, nets the values, and one company pays the difference to the other.

Thus at the end of one year, the fixed-rate payer, Company A, owes 5% x $100 million, or $5 million to Company B. Assuming LIBOR at the time might be 6%, then the floating rate payer, Company B, would owe 6% x $100 million, or $6 million to Company A.

Yet even these payments are netted out to reduce risk exposure. Since 6 – 5 = 1, the floating rate payer (Company B) simply pays $1 million to the fixed rate payer as a result of this swap. Company A doesn’t pay anything, they just receive $1 million. Importantly, throughout the process neither party has the swap’s $100 million notional amount at risk.

There’s nothing wrong with scepticism towards derivatives, it’s just that notional amounts are usually far less dangerous than they sound. Healthy scepticism might be better focused elsewhere, such as on the Net Current Credit Exposure (NCCE) of US companies.

OCC: This “net” current credit exposure is the primary metric used by the OCC to evaluate credit risk in bank derivatives activities.

Looking at the OCC report in this manner, NCCE actually fell 20% in the second quarter of 2009. Thus total risk may be coming down.

OCC: NCCE for U.S. commercial banks decreased 20% to $555 billion in the second quarter of 2009. Legally enforceable bilateral netting agreements allowed banks to reduce the gross credit exposure of $4.6 trillion by 88% to $555 billion. NCCE peaked at $800 billion in the fourth quarter of 2008, and has steadily moved lower due to the impact of rising interest rates and narrowing credit spreads on gross fair values.


We’ll leave the debate as to whether the $555 billion NCCE value is something to be worried about for another post. Clearly this value is still large, but it is far smaller and less shocking than $203.5 trillion.

You can read the full OCC report below.


OCC Report

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