FT Alphaville » Blog Archive » Threats lurking behind the growth of complex finance

Modern finance is based on two key concepts. In very simple terms:

1) You split a given unit of risk into infinitesimally small units and spread it across time (from now into the furthest future)

2) And across space (to many people or entities as possible)

Everything else in finance is just built on top of these two concepts.

So this means that if the risk does pan out in the end, each person in the game loses very little at any given time. However, the question is “What will happen when there is systemic risk that affects the whole financial system?”

The value of derivatives in the the financial system now totals an astonishing 802 per cent of the world’s GDP, providing 75 per cent of global liquidity. Securitised debt is worth 142 per cent of global GDP, providing 13 per cent of liquidity.

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The transfer of risk also introduces opacity – making it fiendishly difficult to see who might be left holding losses if a credit shock did occur or to prevent concentrations of credit risk developing in the system.

Paul Tucker, head of markets at the Bank of England, conceded in a speech last month that the Bank found it hard to interpret M4 - one of the broadest measures of money – because structured finance and hedge fund activity seemed to be distorting the data. Worse, banks’ balance sheets are no longer an accurate guide to activity either because banks are shuffling risk around. So what would happen in a financial crisis remains – as he put it – “unknowable”.

Right now there is little sign of an end to the credit party, nor it would seem to the mounting uncertainty about what might happen when the debt dance ends.