I’ve seen this factoid before, but lifted this recounting from Monday’s editorial in the Financial Times, “Why finance will not be unfettered“:
According to the McKinsey Global Institute, the ratio of global financial assets to world output soared from 109 per cent in 1980 to 316 per cent in 2005. The value of the global stock of equities and bonds reached about $140,000bn by the latter year. On top of this mountain is piled yet another, made of derivatives, whose face value reached $286,000bn in 2006, up from a mere $3,450bn in 1990.
Keep in mind that derivatives’ cash value is a fraction, usually a teeny fraction, of their notional value. But the ballooning of debt and equity outstandings alone is eyepopping.
Why is this a potential problem? Don’t the longs and shorts balance out?
Let’s just start with the market cap of stocks and bonds. Admittedly, 1980 was a high inflation time in the US, but even allowing for that does not fully explain why assets should be valued so much more highly in the financial markets. 1980 also happened to be the start of a long boom due to the spread of computer and communications technology. Perhaps there is another long-boom technology in the wings, but I am unaware of it, and we have global warming, rising energy costs, and other environmental concerns that have the potential to act as a brake on growth.
As for derivatives, it’s not that simple. Corporates and investors may ask dealers for customized OTC derivatives. These are typically hedged dynamically, as part of an overall book. Derivatives firms decompose their positions into the components of risk (delta, gamma, rho, tau), and seek to offset or manage those (for example, dealers often choose to be “short vol” since over time that is a winning trade).