In spite of the financial crisis, the side bet business on Wall Street is still booming. The term "side bets" is a quaint euphemism for the vast unregulated derivatives market. How big is it?
Paul Wilmott, a Ph.D. Oxford-trained applied mathematics specialist and one of the world's leading derivatives experts, estimates the worldwide derivatives market at $1.2 quadrillion. That's 1,000 trillion! To put that number in perspective (if that's possible), $1.2 quadrillion is roughly 20 times the size of the entire world's annual gross domestic product.
It represents an almost inconceivably mammoth derivatives bubble, supported by a continuing, seemingly insatiable demand for speculative side bet products. You can bet Wall Street factories are not about to discontinue pumping out new versions to meet that demand.
Beyond a vague notion, few investors understand the derivatives market, much less the size, scope and precarious implications of the bets they make. Ominously, the reform bill recently passed by Congress does little to address either the abuses or the potential ramifications of the side bet bubble, which only grows larger by the day. Can the financial markets afford these side bets? Can the markets even survive this elevated level of speculation?
Derivatives were originally marketed as products designed to help protect investors against downside losses. These and other hedging strategies were ostensibly created to provide investors with a safety net, encouraging them to invest and helping boost our nation's economy. But derivatives quickly evolved into investments in their own right. At some point, the lab technicians on Wall Street over-innovated, crossing the line between prudent investment and wanton speculation, leaving us with a seemingly endless supply of derivative and hybrid products. In effect, they diverted Wall Street from its traditional capital market role to that of a casino.
These side bets are a distraction from productive investing and a tax on our economy. The capital markets, where companies go to find long-term funding, are languishing, and side bets are one of the principal reasons. If those who inhabit today's side bet world had to put their money to work in the real capital markets, the increased investment would benefit both investors and the companies they fund.
Over the past two hundred years, stocks, bonds and other basic investment products have seen little innovation, and have remained essentially the same entities. The early versions of packaged products and baskets-mutual funds, index funds and, more recently, ETFs-were similarly uncomplicated and functioned well. They were an easy, transparent way for investors to buy baskets of stocks providing portfolio diversity and making investing a bit less risky.
Somewhere along the line, however, hybridized and heavily optioned versions of these products, like leveraged ETFs (LETFs) and inverse ETFs (IETFs) materialized. They were cleverly marketed to sound like those simpler products with established reputations for safety while simultaneously promoting the promise of enhanced performance through leveraging.
The gambit was a marketing miracle. Leveraged ETFs and other option-drenched baskets and buckets sold like drugstore candy on Valentine's Day. The candy looked delicious and was beautifully packaged, so investors didn't look too closely at the contents. They should have. Top heavy with veiled fees and reliant on options and complicated derivative strategies for performance, many of these packaged products required a 3% to 4% annual return just for investors to break even.
Today, because I can find someone to take the other end of the side bet (the option contracts), I can access double the upside and downside of the S&P 500 compounding daily. If the S&P isn't to my liking, I can bet on any number of derivative indexes or industries. How long will it be before Wall Street announces that exchange-traded credit default swaps represent the next "must-have" product for retail investors? How much speculation is too much? How much danger is too much? These derivative bets contribute nothing to the much-needed and missing productivity of our country.