Oops.

They don't go on and ask "cui bono?", so I'll point it out: when financial players are sitting down to a game of poker with other financial players, it's a good day to be the dealer, because he's the only person guaranteed to leave the table richer than he sat down at it.

Of course, in this case the "players" were using depositors' chips and collecting a salary, so I guess in a personal sense they were all guaranteed to "win", too, even if the companies they were managing lost.

"The theory was that financial innovation was making the economy stronger."

That was the presumption or speculation. Calling it theory gives theory a bad name.

"Notional value of U.S. derivatives" is a meaningless statistic.

Most OTC are used to hedge and many are offsetting.

The fear-mongering will only work on those that are completely ignorant of the OTC market. Which fortunately for you is 99% of the country. And in a democracy mob rule, what you need is a majority, not a logical argument.

What Jay said. These graphs are silly methods of illustrating the conclusion they think they've discovered.

If I have a $1 bet with Ezra on a ballgame, there are "$1 notional value of trades" out there. But if Ezra & I redirect the bet to be made through a third party, X (I bet with X, and X makes the opposite bet with Ezra) the "total notional value" of all trades has suddenly doubled to $2. And what if Ezra & I decide to cancel our bet by making another bet directly with each other that cancels out the first one? Now we're all flat (me, Ezra, and X all don't care what happens in the game) so the game's outcome has no economic impact. But there are still "$3 notional in trades" out there. (Scary! Fake money!) If we cancel the bet through X, there are "$4 notional in trades". Again: this is for a scenario where no money need ever change hands (as long as nobody goes bankrupt).

I also wonder idly if the "derivatives" of their graph include swaps (not CDS, but interest-rate swaps). Swaps will have a large "notional value" but only a tiny fraction of those notionals need change hands because the trade is an exchange of interest only, never anything approaching the full amount. One may accurately cite a trade where I exchange 2% of a million for a floating rate that is around 2% of a million right now, as a "derivative with notional value of $1 million", but this would be very misleading because it might be that only relatively tiny amounts of money ever change hands from this trade.

Jay and Sonic, if anything your arguments reinforce the original point. You're both saying the notional value is not important, since the financial industry can generate any notional amount as offsetting hedges that have no effect on the actual economy. So what's the point of these deals?

Ken,

The deals can be offsetting (and in many cases these offsets will magnify measures like "notional", as illustrated), but that doesn't mean they somehow always are (which would indeed be silly; but if that were the case, banks wouldn't have bothered doing any!).

To be clear, I wasn't trying to say that CDS have no economic effect whatsoever, just that "summed notional value" is an obviously bad metric for that effect. Other, better metrics for what they were presumably trying to measure are conceivable. Such metrics might even show what their graph purports to demonstrate (I don't know).

But if the original point was "what's the point of these deals" that's a pretty strange point to assert. Obviously there's been some "point" to these trades, else nobody would've done any! (Banks don't enter into trades with "no point" to them..) A more relevant question is what the incentives for such deals were, did those incentives distort things unduly in some way, can/should those incentives be changed, and therein perhaps lies a good discussion.

But I just don't know what "what's the point of Trade-Type X" is supposed to mean per se. Let's say you're right there's "no point"; then what? They should be banned or otherwise gotten ride of somehow? The real question would then be What's the point of banning them (or even worrying about them)?

The crucial line in all this is Sonic Charmer's "Again: this is for a scenario where no money need ever change hands (as long as nobody goes bankrupt)."

To that one should add, "or illiquid". Because the whole point of these kinds of bets (as with commodity futures, the Ur-derivative) is that the speculators unwind everything to zero before the clock runs out. If you don't, you're left taking delivery of 10,000 dozen fresh,eggs and writing a check to the trucker, or making up the difference between what that interest-bearing security is currently worth and the $1 million in the contract, or whatever other interesting consequences attach to the real-world basis of that "notional" value.

Imagine, for example, that the countervailing bets between Sonic and Ezra go through two parties, X and Y. Then Ezra gets a new job, leaves town, and says, "so long, suckers!" At this point, either X or Y, who thought they were just intermediaries, is going to be out the money they expected from Ezra, but still liable to pay Sonic. And then Sonic says, "Ezra left town, so I'm not paying my side until I get paid off" and the other intermediary gets stiffed too (even if it has already sent Ezra's money to the forwarding address he left).

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