There’s been a lot of attempts to identify and measure bubbles lately. The housing bubble and the commodity bubble are still floating around and yet, they are not the ones I worry about. In my opinion, the largest bubble on the planet is the derivatives bubble and except for ultra-sophisticated finance gurus and central bankers, its size is roughly equivalent to how much it is ignored. Michael Panzner has a fantastic post about this topic on his site and it is one of the few times I have ever called another blog a must read. Please click here and read it.

As I have written here repeatedly over the past few years, I do not respect most financial innovation although I do fear it. With notional values of approximately $500 trillion and global GDP at about $50 trillion, it should not be confusing to anyone where the greatest financial risk lies. And yet, I’ve read and been told that I am exaggerating this risk and that the real exposure to derivatives is a small fraction of $500 trillion. 1/100th is a small fraction but that comes to $5 trillion. 1/1,000th is a small fraction but that comes to $500 billion. What small fraction is nothing to worry about? The deniers and downplayers of CDS and other derivative risk have used many of the arguments that the subprime defenders did by minimalizing it and saying it is “contained.” That was wrong. So is this.

I believe the Countrywide / BAC deal was done to avoid a CDS meltdown. I believe the Bear Stearns / JPM deal was done to avoid a CDS meltdown. And yet, nothing changed really. Yes, some people lost more than they should have. Others gained more than they should have. But as for the derivatives market, it did not change. It is not healthier. No amount of regulation will change it.

Personally, I’d like to see the derivatives market shrink dramatically over time. Unfortunately, it is much tougher to do that than it was to grow it exponentially over the past 10 years. In the first BIS Triennial Survey (as of June 30, 1998) the notional amount of OTC derivatives contracts was $72 trillion. Now it’s $516 trillion. This is the largest bubble. Please read the current Triennial Survey by clicking here.

Our global economy may be bigger than it was 10 years ago, but it is not less risky. The derivatives market is supposed to be the way to reduce risk. On an individual contract if all goes well, that is certainly true. However, as a system, it is not true. Counterparty risk is upon us and while it can be dealt with by bailouts by the US government and others around the globe, the consequences are extreme. There is a tipping point where the assumption of failed risk management by private financial institutions like Bear Stearns will make the value of the underlying assets worth less than the derivatives.