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Derivatives - The Invisible Crisis

Updated: Dec 20, 2022

As of Q1 2022, the total notional amount of derivatives held by US banks is $200 trillion as reported by the Office of the Comptroller of the Currency. The majority of these derivatives are held in interest rates and forex categories.

Though it is an amount that has gradually increased and is manageable on expansion by the risk management system (RMS) that has been developed by the banks over decades and various cycles. But when the economy and the real world go through a cycle like the current one that occurs over many decades then how efficient is the RMS is anyone’s guess.

To understand in a simple manner risk management systems are placed so that the portfolio of assets is not overexposed. This is done by analysing the trajectory of markets and putting limits on the holding. In case of a trigger, the holder has to sell the assets forced by the RMS irrespective of liquidity and other market factors that might lead to a price spiking in either direction.

Thus, in the current environment where interest rates are rising and entering a phase of divergence between estimates and actual policy. It will not be easy to assess the risk with data from traditional cycles. And hence it leads to higher volatility not only in the spot but also in derivatives markets that might result in heavy losses.

In the last 12 months or so, we have witnessed various such moments. Whether it is the Nickel price spiking on LME or UK government bond yields moving double digits within days.

Though the year-end might bring in some relief if nothing else bursts the volatility the cycle is somewhere in the middle and not at the end that’s why next year might result in further moments of panic in markets and create financial instability as the top risk for 2023.

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