The next major threat to Canadian and international financial systems is very likely to come from reckless investors gambling with derivatives, the dangerous betting vehicles that contributed to the 2008 collapse of financial services firm Lehman Brothers and the start of the Great Recession.

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Used properly, simple derivatives (literally: a financial asset that "derives" its value from that of an underlying asset) can reduce the risk of some financial transactions. To use a simple example, they can help bakers guarantee what price they'll have to pay for wheat two years from now. (See sidebar on how derivatives work.)

But big-money gamblers can invest in any of a number of highly risky, extremely complicated kinds of derivatives for purely speculative purposes. When this happens, derivatives are just a form of very dangerous, virtually no-limit, betting.

The problem is that derivatives can blow up. Two former JPMorgan Chase employees are facing criminal charges related to a derivatives trading scandal last year in London that cost the bank $6.2 billion -- enough money to run the City of Vancouver for more than five years. The traders also tried to hide losses from investors and federal regulators.

Cocky JPMorgan Chase CEO Jamie Dimon dismissed its $6.2-billion loss as "a complete tempest in a teapot." Nonetheless, the image of the bank has suffered in the wake of the outrageous caper.

Hair-trigger derivatives, along with laissez-faire deregulation, greed, and poor homeownership policies in the United States, caused the 2008 economic crisis.

Our banks bought toxic US derivatives

In the U.S., unethical financial institutions used a form of derivatives to put billions of dollars of mortgages they knew would be hugely overvalued into bundles that they then sold widely. The Wall Street institutions that did this, and there were many of them, showed no concern for the more than 1.5-million Americans over 50 who lost their homes -- for many, their biggest investment for retirement -- as a result of the collapse of the housing market.

Canadian banks were among those buying the mortgage bundles. They ended up with huge losses that put them in a difficult financial position, and required hefty assistance from Canadian taxpayers.

The use of practically worthless derivatives during the recession helped destroy Lehman Brothers, once an investment banking heavyweight, and pushed insurance giant American International Group (AIG) to the brink of bankruptcy. The U.S. government stepped in to save AIG, for $182 billion. Much earlier, it was the scandalous use of derivatives that led to the 2001 collapse of Enron, a Houston-based energy, commodities and services company, that had employed close to 22,000 people.

On the other hand, when the gambles do work, derivatives can be very profitable. U.S. banks made a record $25.8 billion in revenue in 2012 by dealing in OTC derivatives and securities.

Today, while regulators struggle with banks to get the derivatives market under control, these gambling instruments are being used just as dangerously as they were leading up to the recession.

Market gamblers have created such a massive mess of these derivatives that, should a number of them go bad at the same time, in combination with other financial setbacks, much of the world's economy could be heavily damaged.

The value of derivatives bombs smouldering away around the world, waiting to explode, is almost unimaginable.

It's also almost uncountable. The derivatives market is so poorly tracked that economists can't agree within trillions of dollars as to its real value. Let's go with the conservative estimate of the International Swaps and Derivatives Association (ISDA). They believe that, as of the end of 2012, over-the-counter notional derivatives were worth $US606 trillion.

In comparison, the gross world product (GWP) in 2012, the total of all the real goods and actual services produced on planet Earth, was about US$84.97 trillion, less than one-seventh the value of the derivatives market.

Actual cash at risk from derivatives from all sources is at least US$12 trillion -- still one seventh of humanity's economy. Only a portion of that would have to go up in smoke to cripple much of the economy.

Risky business

If this all sounds crazy, it's because it is crazy. The whole derivatives racket has been allowed to get far out of control.

Ellen Brown of the U.S., an attorney, author, and president of the Public Banking Institute, writes: "A crisis in a major nation such as Spain or Italy could lead to a chain of defaults beyond anyone's control, and beyond the ability of federal deposit insurance schemes to reimburse depositors."

As derivatives are traded in microseconds by computers, we really don't know what will trigger a crash, or when it will happen. Indeed, we have even seen computer glitches themselves almost crash the stock market.

But several international banks have huge liabilities associated with derivatives. In the U.S. alone, JPMorgan Chase has about $70 trillion in derivatives, but is holding only about $2 trillion in deposits and other assets. Bank of America has about 30 times its assets in derivative bets; Citigroup and Wells Fargo have each bet many times their assets on derivatives.

The risks are particularly high in the U.S. because of the concentration of derivatives ownership. Ninety-five per cent of all derivatives there are held by just five megabanks and their holding companies. The top executives from the leading banks meet monthly, in secret, to make sure their firms continue to control the derivatives market.

"The banks in this group... have fought to block other banks from entering the market," Louise Story of the New York Times writes, "and they are also trying to thwart efforts to make full information on prices and fees freely available."

Mike Krauss, a founding director of the U.S. Public Banking Institute, said in August he believes "the biggest banks on Wall Street really aren't safe; they've got so much exposure in derivatives and who knows what else -- they're in danger of going down and taking depositors with them." He suggests people put their savings and investments in a credit union.

HOW DERIVATIVES WORK A derivative is a security that derives its value from some other asset. Traditional derivatives include "put" and "call" options, that give holders the right to sell or buy a certain asset at a certain price; futures contracts, that bind a seller and buyer to close a transaction at a determined price on some future date, are another type. The main advantage or lure of derivatives is that they provide a hedge against the future, and also a way to bet on it for enormous profit. An importer expecting a shipment can use them to "lock in" a foreign currency at a certain exchange rate. But exotic forms with names like the "snowball," "inverse floater" and "power reverse dual currency note," can quickly hang billions of dollars in nominal value on mere quivers in the value of the underlying asset. If we were to have a global financial crisis, a collapse in real underlying assets would put $228.72-trillion worth of derivatives -- about three times the value of the world economy -- at risk at the nine largest banks alone. — Nick Fillmore

Their bets, our risk

We would expect high-rolling banks and financial institutions to be ready to cover the risk they're taking on derivative bets, but that's not the case. Instead, if the Canadian government decides to approach the handling of derivatives the same way the U.S. has, derivatives obligations will be given "super priority" status in the event a big bank were to collapse.

This means that the holders of these derivatives contracts will have first priority for payment. Unsecured creditors such as business depositors, suppliers, and individuals with uninsured accounts (see part one of this series) will go to the back of line.

Even in insured accounts, we will have to see what our federal government decides to do, but it is possible that ordinary folk's pensions and savings beyond $100,000 may go up in smoke if there is a major crisis.

U.S. banks blocking reform

Regulators in the U.S. and Europe have been trying for three years to get the banks to agree to laws that would reduce the risk of a repeat of the mayhem that occurred when Lehman Brothers collapsed.

Roger Lowenstein of Bloomberg writes that regulators want "to bring the derivatives business out of the shadows -- first to get a handle on systemic risk, second to create greater price transparency and narrower margins in a business dominated by a handful of banks, and third to protect the sort of customers who shouldn't be playing with matches."

Big banking is fighting back with what it has most of: money and influence. Says Lowenstein: "The derivatives industry is squeezing Washington like a python."

Bloomberg's Silla Brush and Robert Schmidt, write that, "Wall Street preserved its dominance in derivatives trading with one of the largest sustained lobbying attacks on a single Washington agency."

It appears that yet-to-be finalized U.S. laws will apply to perhaps 20 per cent of the global derivatives market. Large and important parts of the trade will be exempt.

Europe and the U.S. are bickering about how derivatives will be regulated. Europe hopes that a planned free-trade agreement will include financial regulation, but the U.S. doubts this can be done. They do agree that over-the-counter trades will be moved to clearing houses.

It's questionable whether some expected changes will be effective. Regulators do not seem to be pushing to limit either the size of derivatives or the number that any one institution may hold. Instead, U.S. officials seem to be satisfied if, in the event a bank does go bust, derivative holders will allow a cooling-off period before demanding that their claims be settled. Authorities believe this would give them time to (hopefully) transfer the contracts to parties that are not in danger of collapsing.

Canadians dodged the last derivative bullet

It is a little-known fact that at the start of the Great Recession, at the same time as our Big Five banks were getting into trouble, a group of largely naïve Canadian investors got involved in a complicated, and far too risky, $30-billion derivative-related transaction.

While the investors -- individuals as well as representatives of mining companies, governments and financial institutions -- were innocent, there eventually turned out to be plenty of deceit among the Canadian and foreign banks that put the deal together.

When it unravelled, the Financial Post later said, the Canadian banking system avoided a "Financial Armageddon." The Globe and Mail said disaster had been averted by defusing a $30-billion bomb.

The story had played out over a period of six years in the financial pages, while ordinary Canadians -- the people on who could have lost millions of dollars if the bomb had gone off -- heard next to nothing of it.

The investing group of Canadians held $30 billion in a very particular kind of derivative: "ABCP" notes. ABCP notes, asset-backed commercial paper, are promissory notes supposedly backed by assets from a variety of sellers.

The investors believed their $30 billion was safe in the commercial paper. Then the subprime mortgage debacle dried up credit, and no one was buying ABCP notes. The investors could neither sell nor trade what they held.

Moreover, the banks involved went back on their word to provide emergency cash to the trusts that had issued the ABCP. (Something the banks later paid dearly for.) "This left the holders of the $30 billion in limbo," Boyd Erman wrote in The Globe and Mail in Sept. 2011. "Their money wasn't gone -- yet -- it was just locked up."

By 2009, the highly risky derivatives had lost much of their $30-billion value. The potential losses facing hundreds of Canadian companies, pension plans, governments, and more than 2,000 regular investors, were huge.

A messy battle followed in Ontario Superior Court before the investors could manage a sigh of relief. They got new, tradable paper to replace the old notes. The investors were told the revamped paper would be valued at par to their ABCP investment if they held it until 2017, but many chose to walk away earlier at a loss.

The last act came only in Feb. 2013, when Deutsche Bank of Germany agreed to pay $1 million to settle allegations that it had failed to warn investors the product included dreaded toxic subprime U.S. mortgages, which had become practically worthless.

Many of the banks involved in this bizarre fiasco behaved unethically, possibly fraudulently. The fact that several Canadian banks paid huge penalties was hardly covered beyond the financial pages.

Nonetheless, securities offices collected fines of $75 million from National Bank of Canada, $29.3 million from Bank of Nova Scotia, $22 million from Canadian Imperial Bank of Commerce, $6 million from HSBC's Canadian unit, $3.2 million from Laurentian Bank, $3.1 million from Canaccord Financial and $200,000 from Credential Securities.

Harper government down with derivatives

Our Big Five Canadian banks are still handling lots of derivatives. Collectively last year they had total notional derivative bets of $18.6 trillion -- 10 times the entire Canadian economy (GDP $1.82 trillion). RBC stands out for its particularly large derivative holdings, at $7.1 trillion.

If the financial community runs into any kind of a serious problem again -- say, a repeat of 2008 conditions -- the fact that our biggest financial houses are built on such holdings will only raise the risk of a collapse.

The Conservative government has largely shrugged off the danger of a derivative disaster. A Sept. 2013 report from the University of Toronto's G20 Research Group, criticizes the government for failing to carry out reforms that would help protect Canada's financial system against abuses by rogue bankers -- mostly involving derivatives.

Globe and Mail Report on Business journalist David Parkinson echoes the criticism: "When you consider that it was a combination of a largely-unregulated $80-trillion OTC [over the counter] derivatives market and an unsupervised banking industry that brought the global system to the brink of collapse, this is a pretty big deal. Without better oversight, we run the risk that a massive pool of little-understood assets could again blow up in our faces."

The federal government continues to move along, rather slowly, in making changes they hope will keep the derivatives market in check.

Next Wednesday: Is the Harper government planning to "bail-in" the banks with your money?