Is $203 Trillion In Derivatives Held By Goldman Sachs, JPMorgan And Other Top Banks Causing an 'Everything Bubble?'

The scale of derivatives held by major banks like JPMorgan Chase & Co., Citibank and Goldman Sachs, amounting to $203 trillion, has raised concerns about the potential risks these positions might pose to the global economy. The third-quarter Quarterly Report on Bank Trading and Derivatives Activities, published by the Office of the Comptroller of Currency, provides a comprehensive dive into this issue.

This figure surpasses the world's gross domestic product (GDP) by roughly double, highlighting the enormity of the market.

JPMorgan Chase, in particular, is noted for its substantial exposure to derivatives risk, topping the list with roughly $58 trillion in derivatives. The mounting scale of derivatives owned by banks raises several questions and concerns among regulators and investors. 

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The 15-digit number has recently drawn speculation among retail investors on social media platforms like Reddit and TikTok. But as recently as March 9, 2023, Congress held a hearing on managing volatility in global commodity derivatives markets.

A derivative is a contract that derives its value from the performance of an underlying entity. This underlying entity can be an asset, index or interest rate. Derivatives can be used to offset risks in the future or used as leverage to increase gains or losses. 

But it's unlikely the banks are the ones holding these derivatives. Rather, many of the top banks act as market makers for entities buying and selling derivatives. 

While these banks have large derivative positions on their balance sheets, the notional value is a fraction of the total derivatives market. This is because there are typically two sides to every trade: a short and a long. Because each side has a bullish and bearish position, the total size of the derivatives market doesn't necessarily correlate to risk. 

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According to the Federal Reserve, the total long exposure for financial derivatives for hedge funds, for example, has remained largely unchanged since being tracked in 2012. There was a large spike between 2017 and 2018, but as the total derivatives market size increased, the notional value slowly approached 0. Hedge funds have a total long exposure of about $1 trillion.

The banks likely don't hold exposure to most of these individual positions. They are market makers for these transactions and largely facilitate the transactions between parties. Those parties often use the derivatives market to manage risk by hedging their bets or using swaps to limit future exposure.

This isn't to say there isn't significant market exposure to derivatives. By all metrics, the use of derivatives is increasing. Between the first quarter of 2022 and the third quarter of 2023, the notional amounts of derivatives increased by about $10 trillion. If an entity mismanages its risks and becomes too exposed to derivatives, there could be risks associated with those trades. But regulatory measures like the Dodd-Frank Act and higher capital requirements imposed by the Federal Reserve are regularly used to mitigate such risks​​.

A larger concern is the lack of reporting and availability of data surrounding the derivatives market. For example, a recent BIS article highlighted the growing trillions in missing debt created by certain derivatives. Forex swaps, forwards and currency swaps create debts that don't appear on balance sheets and most debt statistics. Swaps such as these are an underlying common denominator for many financial crises and shocks to the system, causing entities to fail or creating funding squeezes. These off-sheet debts are estimated to be at a staggering $97 trillion globally across all currencies and growing fast.

The lack of reporting for these debts makes it difficult to predict future recessions and make policy regulating derivatives.

The $203 trillion in derivatives held by major banks underscores a complex financial landscape where the interplay of risk management and market speculation is pivotal. While banks often act as intermediaries rather than principal holders, the sheer size of these positions raises questions about systemic risk and market stability. 

Regulatory frameworks and reporting standards, although improved, still face challenges in fully capturing the nuances of the derivatives market. The need for enhanced transparency and oversight in the sector remains critical, particularly in light of the growing off-balance-sheet debts that continue to elude conventional monitoring mechanisms.

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