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.

RELATED TERMS
  1. Exchange Traded Derivative

    An exchange traded derivative is a derivative that is standardized ...
  2. Underlying Security

    An underlying security is a stock, bond, currency or commodity ...
  3. Energy Derivatives

    Energy derivatives are financial instruments in which the underlying ...
  4. Hedge Accounting

    A method of accounting where entries for the ownership of a security ...
  5. Equity Derivative

    A derivative instrument with underlying assets based on equity ...
  6. Blue Month

    The month during which there is the greatest trading activity ...
Related Articles
  1. Trading

    Derivatives 101

    A derivative investment is one in which the investor does not own the underlying asset, but instead bets on the asset’s price movement with another party.
  2. Financial Advisor

    SEC Derivatives Rule May Limit Diversification

    The SEC has proposed rules that will limit the use of derivatives by fund managers. Critics believe the rules will impede funds' ability to diversify.
  3. Personal Finance

    Careers in the Derivatives Market

    The growing interest in and complexity of derivatives means opportunities for job seekers.
  4. Investing

    Hedge Funds' Higher Returns Come At A Price

    Learn how hedge funds win big gains for investors - and why they sometimes lose.
  5. Trading

    Was Buffet Right about Derivatives as WMDs?

    Why Warren Buffet described derivatives as weapons of mass destruction, and when can they be helpful or harmful?
  6. Trading

    A Beginner's Guide to Hedging

    Learn how investors use strategies to reduce the impact of negative events on investments.
  7. Investing

    Taking A Look Behind Hedge Funds

    Hedge funds can draw returns well above the market average even in a weak economy. Learn about the risks.
  8. Investing

    The Difference Between Mutual Funds And Hedge Funds

    Both mutual funds and hedge funds are managed portfolios. A manager chooses securities and then lumps them into a single portfolio.
  9. Financial Advisor

    A Fresh Look At The Financial Markets

    Different markets provide unique opportunities and risks for investors. Find out more here.
  10. Managing Wealth

    HF Performance Report: Did Hedge Funds Earn Their Fee in 2015?

    Find out whether hedge funds, which have come under tremendous pressure to improve their performance, managed to earn their fee in 2015.
RELATED FAQS
  1. What Does It Mean to Be Long or Short a Derivative?

    Find out more about derivative securities and what it indicates when traders or investors establish a long or short position ... Read Answer >>
  2. What kinds of derivatives are traded on an exchange?

    Learn about the different types of derivatives traded on exchanges, including options and futures contracts, and discover ... Read Answer >>
  3. What does it mean when a derivative is marked to market?

    Learn what it means when a derivative is marked to market. Mark to market rules have been put in place by global regulators ... Read Answer >>
Hot Definitions
  1. Capital Asset Pricing Model - CAPM

    Capital Asset Pricing Model (CAPM) is a model that describes the relationship between risk and expected return and that is ...
  2. Return On Equity - ROE

    The profitability returned in direct relation to shareholders' investments is called the return on equity.
  3. Working Capital

    Working capital, also known as net working capital is a measure of a company's liquidity and operational efficiency.
  4. Bond

    A bond is a fixed income investment in which an investor loans money to an entity (corporate or governmental) that borrows ...
  5. Compound Annual Growth Rate - CAGR

    The Compound Annual Growth Rate (CAGR) is the mean annual growth rate of an investment over a specified period of time longer ...
  6. Net Present Value - NPV

    Net Present Value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows ...
Trading Center