The derivatives market is a looming omen whose default could collapse the entire world’s economy.  They are so dangerous that Warren Buffett once declared them as weapons of economic mass destruction and stated that he would never be involved in them.  Here are some of the main categories:

1. Credit default swaps
2. Interest rate derivatives
3. Commodities derivatives
4. Equity linked derivatives
5. Over-the Counter derivatives

Derivatives are securities whose value depends on the underlying value of other basic securities and associated risks.  They are essentially leveraged bets.  A buyer of a derivatives contract only needs to put up a fraction of the value of the contract in order to purchase it.  Because of this, the dollar amount that currently exists in the derivatives market has been allowed to mushroom unchecked for decades.  It is currently estimated by the Bank for International Settlements that the amount outstanding in the derivatives market is $1.144 Quadrillion USD. ($1,140,000,000,000,000) That is $1,144 trillion!  Let’s put this number into perspective by looking at the outstanding value of some other assets.

1. GDP of the entire world is $50 trillion $50,000,000,000 (derivatives market is 22 times larger)
2. Real estate market for the entire world is estimated at $75 trillion (derivatives market is 15.25 times larger)
3. The world stock and bond markets combined are valued at $100 trillion (derivatives market is 11.44 times larger)

What is scary about this market is that it is unregulated, it has no universal standards, deals are made with private contracts and it is not transparent.  A collapse in the derivatives market would make the housing collapse look minuscule in comparison and yet it continues to go on unchecked.  A collapse in this market could occur because of catastrophic events like cascades of bankruptcies and nationalizations, or geo-political or geo-physical events.  If the party who accepts this “contract/bet” goes bankrupt this would make the synthetic value of the contract/bet become real money, therefore any large OTC derivative financial firm or brokerage house must be bailed out or taken over by another similar company.  Didn’t we just see this happen with AIG and Bear Sterns? Just imagine if all the bettors at the Kentucky Derby went to the cashier’s window after the race and they were told that the track is bankrupt.

The derivative market needs to be reigned in.  It is very dangerous to not only the financial markets here in the U.S. but its tentacles have stretched to financial markets all over the world.  Its value is about $190,000 for every man woman and child on the planet.  Regulations need to be put in place, and even then it will still be a dangerous market.  Just another reason why everyone needs to own gold in their portfolio.