Since there are no updated figures for the derivatives market since june 2008 ie. since the markets and financial meltdown occured could'nt it be argued that the derivatives market shrank also ? and where would the argument take us in such case ?

What's actually happening is that as the credit crunch deepens, premiums on CDS's increase, making it more profitable to write these contracts even as the risk of writing them increases.

Where it gets really interesting though, is that a good portion of them are written against assets that aren't actually owned, making them in effect naked short positions. For example, if I buy a CDS against the default of a GM bond, I receive the contracted payment on default in exchange for delivering those bonds to the writer. Now, if I don't actually own the bond, it means I have to buy it in the open market. But what happens if there are more outstanding CDS's than there are GM bonds? Perversely, this runs the price of those bonds, even though they're in default. So how do I hedge this? By shorting the common perhaps, but if everyone follows this strategy it creates a huge short position, thus exposure to a bear squeeze. I guess I could buy calls to offset some of that risk, but what would the premiums be, given that call writers are well aware of the potential for a squeeze?

You see how convoluted this gets? This is what happens when you allow insurers to write policies against assets that aren't actually owned. It's the same as if I took out fire insurance against your home. In effect, CDS's became a speculative trade on the likelihood of failure, rather than a means of offsetting marginal risk. For the writer, a "you bet the company" sort of trade based on the belief that the worst case scenario would never materialize, but even if it did, that the govt. would backstop you.

There's a simple way to sum all this up: The market cannot hedge itself. When you put it that way, you can immediately see the fallacy of trying to insure financial assets based on the value of other financial assets. It's a game of musical chairs is all, and you and I, through the failure and outright corruption of the agencies responsible for regulating the market, are the ones left standing when the music stops.

ebear