Chapter 44 - What are Derivatives?

A derivative is a contract between parties whose value is dependent on the value of an unrelated asset. Its value fluctuates with the value of the underlying asset. Common underlying assets include stocks, bonds, commodities, interest rates, currencies, security, and market indexes. The derivative is an arrangement or product such as a future, option, or warrant whose value derives from the performance of an underlying asset. The underlying asset is often referred to as “underlying”. The underling might even be another derivative.

Derivatives can be considered useful:

Some common derivatives include ‘forwards’, ‘futures’, ‘options’, and ‘swaps’. Variations of these include: ‘synthetic collateralized debt obligations’ and ‘credit default swaps’. There are some similarities between derivatives and insurance, but insurance operates as a separate industry. Derivatives are a main category of financial instrument. Two other categories of financial instruments are stocks (equities or shares) and debt (bonds and mortgages). Derivatives tend to be traded over-the-counter (OTC) which is off-exchange or on an exchange. (ETD) The derivative contract between the parties would specify the conditions. The conditions would include the dates, the definitions of the underlying variables, various contractual obligations, and the method of payment.

Derivatives allow traders to hedge their bets. ‘Hedging’ can protect organizations against unexpected changes in values. It can be convenient to protect oneself against price changes in everyday commodities such as wheat to protect against crop failure. Traders would buy and sell ‘future’ contracts which are an agreement to buy wheat or rice, for example, at a fixed price at a fixed date in the future. In the 1980s, futures trading began to dominate markets. The trading was in futures and options on bonds, currency, and shares. The business of hedging became profitable on its own. Swaps and options became popular. Swaps allowed persons to buy of sell at a certain price but retain the privilege to profit if the market suited. Swaps allowed an exchange of something. These would typically be on interest rates or currency. This might enable a company to swap a fixed interest rate for a floating rate. The derivative can aid cash flow by bringing costs from one time point to another. The derivative does not imply any ownership of the underlying asset. It allows a disconnect between ownership of an asset and participation in a market. The assets might be bonds, currencies, shares, or goods. The goods might be metals, energy sources, agricultural produce and other items.

Derivative contracts can be divided into two groups:

Derivatives allow speculators masquerading as ‘investors’ to bet on prices without actually purchasing the assets involved. These derivatives can also be ‘leveraged’ to create a situation where a small change in the value of an asset can cause a significantly larger change in the value of the derivative. An option call contract could be arranged such that a price change from $100 to $101 might result in a doubling of the value and a price change of the underlying asset down to $99 might make the derivative worthless. This can lead to huge profits or massive losses. The concept of investing is to store wealth and make a mild gain to offset depreciation. Investing has morphed into gambling and bad outcomes will follow. With derivatives, there is a winner and a loser in a net-zero arrangement. Overall this is not investing as there is no net gain. The winners rely on finding gullible losers to scalp. The winners may be smart but smart requires someone less smart to bet against. Provided money changes hands the smart will win from the less smart losers. The game requires gullible people with money to lose to be drawn in. Superannuation fund managers, state governments, and local government pension schemes make good dupes.

Derivatives give no net increase in wealth to the world.

A graph of Derivatives Notional Amounts Outstanding. Creative Commons Attribute - Andy Chalkley.

Derivative contracts have another interesting characteristic. They have a zero total. For each winner, there is a loser. The win and the loss cancel each other. Many derivatives have become incredibly complex using advanced mathematics in their composition. The banks and hedge funds that trade in these use significant leverage. This means they are using a small amount of their own money topped up with borrowed money. This magnifies the return or loss. This magnifies the risk. The risk can be greater than professional investors realize.

In some instances, the risk is spread such that if there is a surge in defaults, many investors take a small hit rather than a small number suffering large losses. This appears as a breakthrough in risk management. However, a situation has been created where institutions can take on huge risk. To make greater returns, some are taking on unrealistic levels of risk. It only takes a few to make inappropriate errors to bring the system down.

The magnitude of the derivatives market has grown from a useful business service to a financial monster, often estimated at more that $US1200 000 billion. As a reference, According to the World Bank, the 2013 nominal Gross World Product was about $US75 590 billion. The derivatives monster is fifteen times the magnitude of the sum of the GDP of all nations. There is some controversy on how to calculate the magnitude. Whatever the result, the derivatives market is frighteningly large.

A diagram comparing the magnitude of Derivatives, World GDP, World Debt, and World Money. Creative Commons Attribute - Andy Chalkley.

Derivatives were historically used to hedge against risk. What is scary is that they can also be used to acquire risk. For very little outlay, one can bet on the value of an asset in a manner to make massive gains or large losses. This is speculation on steroids. This is the very essence of evil.

New Messiah says: The making of money from money is the very essence of evil.The making of money from money is the very essence of evil.

Yet the perpetrators do not realize the error of their ways. The practice also includes short selling. In this procedure, a product is sold that is no owned by the seller. The seller purchases the item just prior to the final selling date. These are truly evil practices.

Derivatives bomb. Creative Commons Attribute - Andy Chalkley.

Derivatives got a bad name in 1995 when a trader at Barings Bank by the name of Nick Leeson made investments in futures contracts that caused a $US1.3 billion loss for the bank. This bankrupted the centuries-old institution. This type of activity is too dangerous for a planet with a global GDP of $US75 590 billion. These banks do not readily know who owes what to who. A single investment bank collapse could cause a contagion that could bring the whole finance system to an untimely end.

Phone boxes. Creative Commons Attribute - Andy Chalkley.

It is not as if we have not had a warning shot about the dangers. It was this credit-default swap market that was the primary cause of the market crash in 2008. A financial sneeze could bring our financial system to its knees. It is easy for a trader to make a bet that is so large that a failure is beyond the capacity of the institution to pay. In one instance, AIG could not pay on $50 billion in derivatives debts. It had the potential to bring down some of the largest banks in the world. The money at stake in a transaction can exceed the capital of the trading operation. The derivatives trading has become so complex that it is difficult to know who owes what to who and what the effect of a default might be. The 2008 financial crisis demonstrated that derivatives trading is out of control. This trading has the potential to bring down the entire financial system of the world. Correcting this situation is politically difficult because the politicians and political parties have come to rely on the ‘generosity’ and ‘helpful assistance’ given by the finance industry. The politicians will betray the electorate. Hell on earth will be the result of inaction against the menace of derivatives. It will be the end of the world as we know it. Our only hope as a civilization is to smash these derivatives and forever ban them. The financial system is too important for civilized life to be privately run and controlled. This financial system entraps the unwary cities, states, and nations into unpayable debt as proposed by Moses. These entities are bled and asset stripped. The banks that carry out the rout grow richer with money they can never hope to spend. This leads to a gross hoarding of money until those that produce the products and services that are needed for life are so short of money that the whole foundation of the money system collapses. The whole system might be operating within the law but the laws are wrong. The derivatives system is legal, but it is a complete corruption of a money system. The whole activity of ‘making money from money’ adds nothing to civilization and damages the livelihood of communities, cities, states, and nations. When the system collapses, billions of people will be placed into abject misery and the system is so broken that it will be difficult to repair. We cannot afford to not repair it. Fixing it is easier than living through the pain of collapse.

You should know the solution by now. It is Glass-Steagall. A complete separation of Investment Banks from Commercial Banks.