Surging demand for derivatives is making financial markets more vulnerable to any slowdown in the global economy, said economists and executives at the World Economic Forum.
“You can easily get liquidity from the market every second for anything,” said Bank of China Vice President Zhu Min at a panel discussion on the global economy in Davos, Switzerland. “We really don’t know what the risks are.”
The use of derivatives grew at the fastest pace in eight years during the first half of 2006 as a glut of cheap money allows investors to bet more borrowed funds in financial markets. That’s prompted policy makers including European Central Bank President Jean-Claude Trichet to say investors may not be accurately assessing risk.
Montek Singh Ahluwalia, deputy chief of India’s planning commission, said derivatives demand is a problem because “people don’t have much experience of this.” Nouriel Roubini, chairman of Roubini Global Economics, said there’s danger of “much slower growth in the rest of the world” outside the U.S. “than is priced into the markets.”
Several measures show perception of risk is near historic lows. The gap between the yield demanded by investors to hold emerging-market and U.S. government bonds narrowed to a record on Jan. 17, according to JPMorgan Chase & Co., while the amount of debt used to finance European buyouts rose to 8.7 times earnings in the third quarter, the most ever.
The Dow Jones Industrial Average this month rose to a record.
Derivatives are financial instruments derived from stocks, bonds, loans, currencies and commodities, or linked to specific events like changes in the weather or interest rates. The face value of the contracts jumped 24 percent to $370 trillion in the first half last year, according to the Bank for International Settlements.
Trading in credit-default swaps, the fastest-growing derivatives market, has helped spur record earnings for banks including New York-based Morgan Stanley and Goldman Sachs Group Inc. The contracts are financial instruments based on corporate bonds and loans that are used to speculate on a company’s ability to repay debt.
Economists differed on the outlook for the global economy this year. While Roubini said he’s concerned a slowdown in the U.S. economy will spread to Europe and Asia, Laura Tyson, dean of the London Business School, said “the rest of the world is in significant growth mode.”