Summary
This post looks at the size of the derivative market and seeks to understand the economic exposure to the financial system from risks embedded in this market.
Analysis
The gross value of CDS instruments were $400 billion for the Lehman Default event. The Depository Trust & Clearing Corporation expects the net payout on CDS instruments to be $6 billion. The net credit risk is normally estimated at one fiftieth of the gross value and this is the net amount which will be settled after eliminating various eliminating counterparties involved in the trade.
Moral of the story is that the expected value of net credit risk on the scary $1,300 trillion derivative market is nearer $27 trillion; and not all of it will go bad.
$1,300 trillion is a headline number which terrifies and yet it does not really represent the true exposure.
The author does believe that the market needs to be unwound so that the size reflects an economic transaction between a person owning an underlying security who seeks to protect risk and the protecting bank/insurer. Having counterparties profiting from speculation should not be permitted at anytime; particularly now because an insolvent counterparty in the settlement chain can result in total exposure rising rapidly from the net credit risk towards the gross value.
