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You have to dissect the multi-trillion dollar figures thrown around. 80% of this total exposure is in the form of plain vanilla Interest Rate Swaps.

In a vanilla Interest Rate Swap, the 2 parties involved in a transaction are only exchanging fixed interest payments for floating interest payments on an agreed-upon notional. It is not the notional itself that is being exchanged. Please place these huge figures in their proper perspective

For example: 2 parties may engage in a Swap transaction on a $100million notional amount. They are not exchanging the entire $100million. They are only exchanging interest payments on that $100 million on a monthly, quarterly, semi-annual or annual basis (whatever they agree to), so the true exposure is nowhere near the $100 million notional amount of the swap. If a bank on one side of the transaction goes under, the other side hasn’t lost $100million, or anywhere close to it.

That being said, things are not looking too stable. It is very likely that at least one European bank will fail, which could set off a chain reaction in the US with some of our big banks which are hanging by a thread.

Derivatives are more complex than just ‘side bets’ and they have an important role to play in the world of finance and international banking. They allow firms to hedge exposure to obligations such as interest payments, and project financing costs just to name a few uses. Yes, there is an element of speculation involved, but the market is very liquid and there are regular bilateral netting and portfolio compression cycles that take place. These are processes by which offsetting trades are effectively “torn up” thereby removing them from the balance sheet of the banks involved in the transactions. Too much to elaborate upon here, but these compression cycles occur regularly and every big bank with derivatives exposure participates. Think of these cycles as maintenance, in which the deadwood and underbrush are removed in order to prevent a potential forest fire.

Thanks for inserting some sanity into this discussion. To elaborate further:

To those that want to ban all derivatives:

When a farmer pre-sells his crops, that is a derivative

If you own stock options on your employer, that is a derivative

If I want to insure a loan I am making I buy a CDS, a Credit Default Swap from an insurer. If that insurer decides to sell that exposure to another insurer that doubles the NOTIONAL VALUE outstanding but it does not increase the amount at risk.

For example, I lend US Steel $100 million. I buy a CDS from Goldman for $500,000. They turn around a insure their risk with JP Morgan for the same amount. The CDS’s total NOTIONAL VALUE is now $200 million, but there is ONLY $100 million at risk.

Take these total derivative numbers with a grain of salt. Much of it is an offset of another position.