Derivatives Time Bomb: Meaning, Overview and FAQs

What Is a Derivatives Time Bomb?

"Derivatives time bomb" is a descriptive term for possible market mayhem if there is a sudden, as opposed to orderly, unwinding of massive derivatives positions. "Time bomb" as a reference to derivatives is a moniker attributable to Warren Buffett.

In his 2002 Chairman's Letter for Berkshire Hathaway, he said, "We view them as time bombs, both for the parties that deal in them and the economic system." In 2016, in the annual Berkshire Hathaway company meeting, the legendary investor warned that the state of the derivatives market was "still a potential time bomb in the system—anything where discontinuities can exist, can be real poison in markets."

Understanding a Derivatives Time Bomb

A derivative is a financial contract whose value is tied to an underlying asset. Futures and options are common types of derivatives. Institutional investors use derivatives to either hedge their existing positions or to speculate on various markets, whether equities, credit, interest rates, or commodities.

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. The world learned this during the financial crisis that roiled markets in 2008, primarily through the subprime mortgage meltdown with the use of mortgage-backed securities (MBS).

The Dangers of Derivatives

A number of well-known hedge funds have imploded as their derivatives 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

In the 2002 annual report of his company, Berkshire Hathaway, Buffett stated "Derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal."

Warren Buffett goes further a few years later, devoting 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."

Though he believes in the danger of derivatives, he still utilizes them when he sees an opportunity, in a manner that he believes is prudent and that won't result in a large financial loss. He primarily does this when he believes certain contracts are mispriced. He stated this in his 2008 Berkshire Hathaway annual letter.

The company held 251 derivatives contracts that he said were mispriced at inception. Furthermore, the specific derivatives contracts Berkshire Hathaway held then did not have to post significant collateral if the market moved against them.

Financial regulations implemented since the financial crisis are designed to tamp down on the risk of derivatives in the financial system; however, derivatives are still widely used today and are one of the most common securities traded in the financial marketplace. Even Buffett still utilizes them and by doing so has earned a significant amount of wealth for himself and Berkshire Hathaway's shareholders.