DEFINITION of Derivatives Time Bomb

Derivative time bomb is a descriptive term for possible market mayhem if there is sudden, as opposed to orderly, unwinding of massive derivatives positions. "Time bomb" is a moniker attributable to Warren Buffett, who as recently as 2016 warned that the current state of the derivatives market is "still a potential time bomb in the system if you were to get a discontinuity or severe market stress."

Institutional investors use derivatives to either hedge their existing positions, or to speculate on various markets, whether equities, credit, interest rates, commodities, etc. The widespread trading of these instruments is both good and bad because although derivatives can mitigate portfolio risk, institutions that are highly leveraged can suffer huge losses if their positions move against them, as the world learned during the financial crisis that roiled markets in 2008.

BREAKING DOWN Derivatives Time Bomb

A number of well-known hedge funds have imploded in recent years as their derivative positions declined dramatically in value, forcing them to sell their securities at markedly lower prices to meet margin calls and customer redemptions. One of the largest hedge funds to first collapse as a result of adverse movements in its derivatives positions was Long Term Capital Management (LTCM). But this late 1990s event was just a mere preview for the main show in 2008.

Investors use the leverage afforded by derivatives as a means of increasing their investment returns. When used properly, this goal is met. However, when leverage becomes too large, or when the underlying securities decline substantially in value, the loss to the derivative holder is amplified. The term "derivatives time bomb" relates to the prediction that the large number of derivatives positions and increasing leverage taken on by hedge funds and investment banks can again lead to an industry-wide meltdown. 

Defuse the Time Bomb, Says Buffett

Warren Buffett devotes a lengthy section to the subject of derivatives in his 2008 Annual Letter. He bluntly states: "Derivatives are dangerous. They have dramatically increased the leverage and risks in our financial system. They have made it almost impossible for investors to understand and analyze our largest commercial banks and investment banks." Financial regulations implemented since the financial crisis are designed to tamp down on the risk of derivatives in the financial system. However, no one, not even the Fed, can say for sure whether the bomb has been defused.