Bank derivative portfolios gained while markets crashed

OTC derivatives in June to December 2008 (second half)

Institutional derivatives are a major component of the financial meltdown, and the second half of 2008 was a particularly interesting period with many financial events never before experienced in history. I am very excited to be writing about this, as what happened in 2008 will be written about in textbooks and studied by historians.

The Bank for International Settlements publishes semi-annual statistics on global OTC (over-the-counter) derivatives. These are institutional derivatives traded between major banks with little or no public or regulatory disclosure. Additionally, because they are OTC, the instruments have poor liquidity, little or no price transparency, and are subject to counter-party risk in the event the other party to the contract defaults. Financial institutions hold these instruments mostly off-balance sheet, where they can hide the contract exposures and market values from investors and regulators.

We are talking contract exposures here into the hundreds of trillions of dollars and mostly concentrated among just a handful of major institutions. The dollar amounts are far above the total global stimulus/bailouts and global central bank lending. There's some food for thought.

For the period from the end of June to the end of December 2008, here are the BIS statistics:

Notional value, and gross market value

The derivatives statistics mention both total notional values ($592 trillion) and gross market values ($34 trillion) at end of December 2008. For perspective, total GDP from western countries in 2008 was approximately $40 trillion. These figures are only amounts for OTC traded derivatives; there are also exchange traded derivatives not included in these figures.

The notional value is the value of the underlying asset represented by the contract or the nominal face value amount. This is often an amount that is never transferred between parties, but the contract represents a claim to assets worth this much, under some conditions. In other words, the contract allows a transfer of this size to occur, though such a transfer may never occur.

The gross market value, in contrast, is the market price of the derivative contract. Banks hold both long and short positions for derivatives, so the gross market value is simply the absolute value of the market price of the contract, whether long or short.

Here's an example: let's say GOOG trades at $430 a share and there is a call option (a stock derivative) with strike value $600. After eating some green shoots and getting high, you decide to buy one call option quoted at $18.17 (multiplier is 100).

To make the example more realistic in the OTC derivative world, this options trade wouldn't go through an exchange but rather would occur directly with your counter-party. It is therefore not clear what the market price or market value would be, because these kinds of options may trade rarely.

Pay close attention to this part! This is where the monkey business starts.

Your firm, who wants to buy the call option, might phone up JP Morgan's derivative trading desk and negotiate a price for the derivative. To complete the trade, your firm pays $1,817 to JP Morgan. Your firm now holds 1 contract “long” and JP Morgan holds the same contract “short”. Under certain conditions, your firm may now receive 100 shares of GOOG. Does the counter-party have those shares? Not necessarily. They have sold your firm a promise, which they can create from thin air, and have earned $1,817 of income without expending any capital or borrowing any money. Now your firm must hope that JP Morgan remains solvent and is capable of delivering your 100 shares, otherwise your contract becomes worthless.

Note that this derivative trade did not involve the transfer of any underlying (stock). It is recorded on the books of each party, and now each party has a new derivative position. The notional values are $43,000 for each firm. How about the gross market value?

Well, what is the market value for this derivative? When you last traded it, the market value was $1,817 (determined by your firm and JP Morgan). But let's say that a year passes, and you have no new information about the trading value of the derivative. Perhaps nobody else got high enough to buy a $600 strike GOOG call, or somebody did trade it OTC but did not share the value of their trade with you.

This example used a stock option, which is easy to value even in the absence of active trading. OTC derivatives traded by banks, however, often have obscure and illiquid underlying instruments, and the derivatives themselves may hardly ever trade. Also, in such a thinly traded market, a single player can make the market by making a trade. Would the resulting price be reasonable? The Federal Reserve and US Treasury recently started buying illiquid assets from banks. It is very easy to imagine how this could result in trades that price derivatives at unrealistic values.

Those real-world conditions make it extremely tricky to determine the value of an OTC derivative. The values can be stale, skewed by trading partners, or completely fictitious based on assumptions in the absence of real trading. Banks still report their market values, and one thing we know for sure is that whatever position value they use, it forms the value of their portfolio.

The question remains, how much is your portfolio worth?

(From the above example), imagine that your firm holds a number of obscure derivatives traded OTC, and none of their prices can be accurately determined because nobody in their right mind would trade them. When somebody asks, “what's your portfolio worth?” your firm still has to come up with a number. So you come up with a number, and that number may even have an important role such as demonstrating collateral for business you conduct or receiving free overnight loans from the Federal Reserve. Your counter-party, who holds some related positions, goes through a similar exercise. Perhaps your counter-party sells one those derivatives to the Federal Reserve, thus determining a market price. Does the price have any meaning in the real world?

Sounds pretty messy, right? That's where we are.

Major changes in second half of 2008

There was a marked decline in the notional amounts outstanding of OTC derivatives. This decline “is the first since collection of the data began in 1998” (from BIS report) which is a very notable event in a market which until now has consistently grown by trillions of dollars every year. There are a few ways the notional amounts can decline:

In general, the shrinking of outstanding notional amounts suggests deleveraging and deflation of assets. Exactly what goes on within the banks' books is not well known due to lack of public disclosure and the secrecy around off-balance-sheet amounts. Let's look at the numbers we do have from the BIS report. All of the values are in TRILLIONS.


Notional value June 2008

Notional value December 2008

Change ($)

Change (%)

Total contracts





Foreign exchange





Interest rates















Credit default swaps










Those figures show a total notional value decline of $92 trillion over half a year, with the biggest decline in interest rate contracts. These are enormous declines.

Then we move on to gross market values, and these paint a different picture. Remember that these are the market values of derivatives in the portfolio, as reported by the banks.


Gross mkt value June 2008

Gross mkt value December 2008

Change ($)

Change (%)

Total contracts





Foreign exchange





Interest rates















Credit default swaps










This table of gross market values strikes me as very interesting! There is a significant increase in gross market values of derivatives, as reported by the banks. There is an especially large increase in market values of the two favourite kinds of derivatives banks play with: interest rate swaps and credit default swaps.

Gross market values of interest rate swaps have doubled over this brief period!

The BIS report also says gross market value for single-name CDS essentially doubled!

And the only loser in the derivatives game? Commodities contracts, with the largest % decline in notional values and the only decline among gross position values.

Questions this raises

Globally, there are just a few banks which make up most of this OTC derivative market. The largest of these is JP Morgan, who essentially made all of their 2008 earnings from derivatives trading. (Without derivative trading profits, JPM would have had no net income in 2008.) It's also difficult to ignore the fact that JP Morgan has emerged as the single largest and “healthiest” big bank remaining solvent in America.

I suppose we shouldn't be surprised that the largest derivative player also emerged as the healthiest: looking at the above tables, we see that even while global markets crashed and deflation hit the derivative books (notional decline), the value of bank derivative positions (gross market value) increased!

This means that derivative instruments held by banks gained value, if the bank was on the right side of the trade. Since JP Morgan (and Goldman Sachs) profited from derivative trading even while markets crashed, we can assume that they were on the right side of many trades. This ballooning gross market value, the value of their positions, provided life-saving gains in a time of write-downs and deflation.

Some of the market value positions are certainly no miracle. CDS contract prices increase with market turmoil and risk so it is natural to see a big jump in CDS market values. However, given the questionable nature of OTC derivative pricing and total lack of transparency in instrument valuation, I have suspicions about how these gross market values came to be.

In the years I have tracked these derivatives statistics, the boom years brought a logical increase in both notional values and gross position values. I find it counter-intuitive that the gross market values increased at a much greater pace than normal while nominal contract amounts outstanding crashed dramatically.

This is a complex and mysterious market, but I have two possible explanations for what might be going on, and they're not mutually exclusive:

I would not be surprised if all this unprecedented central bank money creation resulted in money flowing into the OTC derivative market, where it inflated contract prices and helped delay major losses at the banks.

- Perpetual Bull