The $55tn tail wagging the swaps dog…

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A report out last week from the Commodity Futures Trading Commission (CFTC) certainly raised my eyebrows when they stated that they had underestimated the size of all the outstanding swap contracts on its data repositories. According to CFTC officials familiar with the case and cited by the Wall Street Journal, the discrepancy may be as high as $55 trillion!! Now, that is one helluva checking error! Another official however estimated the difference at $10 trillion. One way or another, when the amount is in the trillions as opposed to mere billions, it’s time to sit up and take notice.

A failure to determine the size of the global derivatives market and how much these instruments were really worth was of course at the root of the 2008 financial crisis. It sees that not only does history repeat, but the repetition process seems to get ever faster in recent years.

To increase transparency in what is probably the most opaque and obscure marketplace within the financial arena, new rules were adopted to detect any significant increase in risk before the overall financial system collapses. Or so they thought. The appropriate authorities receive data from the CTFC, in particular concerning the swaps market (primarily interest rates) in order that they can act in time. The Dodd-Frank Act signed into federal law in the US only recently in July 2010 introduced the most significant change to financial regulation since the reform that followed the Great Depression, imposing severe rules regarding the swaps markets.

To increase transparency in the derivatives market, the CFTC also adopted several specific measures including the reporting of weekly swap data, which they have been doing since the end of last year. The CFTC acknowledged the error in a footnote to its weekly swaps report in which it disclosed that the largest data repository, the Depository Trust & Clearing Corp. had informed CFTC that due to a technical error the values relating to the interest rate class have been understated. They also refer to a second error committed by another repository, part of the CME Group.

Whether it is $10 trillion, $55 trillion we are still talking about a gigantic number that may surpass the actual size of the US economy by as much as three times. Yes, that’s true, three times! US nominal GDP is presently around $16 trillion and the implications of this are mind numbing. For example if the size of the error was $55tn and a loss equivalent to just 10% was made by one side (or collective) of the counterparty then the hole in the US economy could equate to 1/3 of GDP!

While everyone is talking about a 12% cut in quantitative easing, amounting to a mere $10 billion, it seems that nobody cares about a figure 1000x higher in thesupposedly transparent swaps market. The saying of the “tail wagging the dog” springs to mind!

Filipe R Costa

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