The term 'derivative' is pretty broad. Everything from a listed option on a stock or a future can be considered a 'derivative' because its value is derived from an underlying asset.
The derivatives as described in this article are primarily Interest Rate Swaps which are traded "Over The Counter" or directly between the two parties. They are not listed on an exchange, nor are they something that individual investors or mutual funds would trade or have any exposure to.
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.
Under Dodd-Frank, banks will be forced to have these products centrally cleared, meaning that each side of a transaction will face a clearing house instead of facing another bank directly. In essence; each bank will have to post collateral based on the value of the derivative contracts to which they have exposure. This collateral will (in theory) protect the counterparties of those transactions if a bank were to default.
You’ve made this very understandable. Well, I had to look up “notional,” but the student has to do at least a little homework.
From your explanation, this article appears to be a little over-the-top.
Thank you for taking the time to explain.