Chapter 50 - Why Are Derivatives Dangerous?

 I very strongly suggested that you websearch: “why are derivatives dangerous”.

Derivatives played a role in the near near collapse of the banking system in the Global Financial Crisis. Derivatives were involved in the significant problems at Barings Bank in 1995, Long-term Capital Management in 1998, Enron in 2001, Lehman Brothers in 2008, and American International Group (AIG) in 2008. Warren Buffet viewed derivatives as ‘time bombs’ in the economic system. He described them as “financial weapons of mass destruction”. [2002 Warren Buffett] As a politician, you need to fully understand the instability created by derivatives.

New Messiah says: “Your human love of money is blinding you to averting a preventable disaster.”

Derivatives have become the most dangerous activity in the world. We are not facing a nuclear Armageddon. We are facing financial Armageddon. Derivatives trading is sometimes estimated to be more that $1.2 quadrillion. ($1200 000 billion). That exceeds the magnitude of the entire world economy by a factor of ten. Although some estimate a figure of twenty. Although the figures are controversial, the implications for the financial system are dire. Some say that another financial crisis in inevitable. The derivatives market is complex and it is unregulated. Unfortunately, world leaders lack the power or knowledge to regulate or control.

A derivative is a contract between parties whose value is dependent on the value of an another 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. It allows a bet to be placed on something without owning the something. 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”. When selling a derivative you are not selling anything real. You are effectively betting on the price of some other object. Their name relates to the word ‘derived’ which leads to its meaning as ‘based upon’ or ‘created from’. A derivative is derived from something else which becomes the underlying object. So a derivatives market is different to any other market as nobody is actually selling any real physical objects. derivatives have a zero-sum total. Just as in a casino, nothing of worth is created by derivatives. Some derivatives have a useful business purpose, however, most are created to allow speculation on a scale that is difficult to comprehend. Derivatives have become a significant risk to the stability of the world’s financial system.

Derivatives can be useful. If, for example, you are selling a submarine to a foreign nation, your profit may only be a few percent. It may be useful to have a derivatives position on the exchange rate so that you know exactly what you will receive in the sale. However, very few derivatives have anything to do with trade. Derivatives are taken out on any number of things. You can even take a derivatives position on the weather!

An OCC (Office of the Comptroller of the Currency) report contains the following definition: a derivative is a “ contract whose value is derived from the performance of assets, interest rates, currency exchange rates, or indexes. Derivative transactions include a wide assortment of financial contracts including structured debt obligations and deposits, swaps, futures, options, caps, floors, collars, forwards, and various combinations thereof...” This makes the derivative nothing more than a ‘bet’ between two parties. Money is to change hands at some date in the future. Ownership of the underlying asset is not required by either party.

In any real market or a stock market, you take possession of real objects and you pay for your purchases at the end of each transaction. In a derivatives market, the procedure is different. At the appropriate time, you ‘square off’ your ‘buy position’ with a ‘sell order’. You pay or receive the difference between the selling price and buying price of the derivative. Nothing of value is created by derivatives.

A trader can enter into a contract of significant value creating a positive balance at the derivatives exchange. The balance is called the margin and is a percentage of the contract value (exposure). This enables the person to magnify the risk and the size of the gain or loss. If the margin is twenty percent, the trader can buy $5000 with only $1000 margin. Thus the gains or losses are magnified fivefold. With these methods available, extremely high returns are possible. The exposure for a company can be larger than the total stock of a company. Any default can bring down a company or large bank. One Investment Bank failing has a cascading effect.

Phoneboxes. Creative Commons Attribute - Andy Chalkley.

Take an example. If Company A has an exposure to Company B and Company B has an exposure to Company C and Company C collapses, does Company C bring down Company B and does Company B bring down Company A. We can manage without Investment Banks but we cannot manage without Commercial Banks. Investment Banks and Commercial Banks have created financial ties since the repeal of the Glass-Steagall laws in 1999. Investment Banks and Commercial Banks need to be financially separated with a reintroduction of Glass-Steagall legislation.

Derivatives trading may be very exciting for the participants, but it means that the financial system has been commandeered and turned into one big ‘Casino’ with potentially very dangerous outcomes. The derivatives procedure creates risk where none occurred. Speculators have become the significant part of the derivatives markets. They have no interest in hedging their own exposure. They use derivatives to bet on the prices of commodities. The magnitude of the risk has come to exceed the total global world output. The activities of the traders have turned the world finance system into a global casino. Look at the dollar figures in the following diagram:

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

The CDS or ‘credit default swap’ effectively insures against a debtor being unable to pay his debt. One party pays the other a premium. If the debtor fails to pay up, the CDS purchaser gets a payout from the CDS seller. ‘Credit default swaps’ were intended to be a method for those who hold debt to insure themselves against default on behalf of the borrower. In the modern world, a buyer of the CDS need not own the debt. An investor can buy CDSs on a third party’s activities. This creates a synthetic CDO. This means that you can place a bet on some entity’s demise.

Derivative contracts have a zero-sum total. The gain and the loss cancel each other. Derivatives are often exceedingly complex requiring advanced mathematics beyond the comprehension of mere mortals. Banks and hedge funds often use borrowed money to magnify the gains or losses.They use significant leverage. A small amount of their own capital is topped up with borrowed money. This magnifies the risk and the size of the gain of loss.

The very nature of derivatives is that there is always a winner and a loser. There is a zero-sum total. This means that money is simply shifted from person A to person B. There is no benefit to society. A gets to hoard more money and B gets to hoard less money. Hoarded Money is shifted from A to B. It counts as a movement of a large sum of money which means that the money technically becomes Circulating Money for a short time, but no goods or services moved and no benefit was provided to human society. The participants are using money that was created as a debt to someone for the purpose of accumulating a hoard of money. The speculator hoards money simply so that he has more money than yesterday. He has no hope of spending it on anything that assists civilization.

New Messiah says: “This whole practice of ‘making money from money’ is a straight out evil and a menace to the operation of civilized society.”

The whole financial industry has embraced a system of speculation where no new products or services are created. Money is moved from person A to person B as a form of competitive enrichment where money goes from one hoarder to another hoarder. The money of the world in one great casino style system where the bets are called derivatives. Some foolhardy betters make bets beyond their capacity to pay in a manner that could bring down their own house of cards. Their failure to pay may put the gains of all participants to zero. The whole stack of cards falls. Unfortunately, this would incapacitate the entire world money system. The solution is to stop the madness or isolate their money making exercises from the real economy that feeds, clothes, and houses us.

New Messiah says: “I ban derivatives.”

The only sure way to accomplish this is to separate their activities from the activities of the Commercial Banks that operate as high street banks funding local businesses and family mortgages. The system is commonly called Glass-Steagall. This is a system where Investment Banks are separated from Commercial Banks such that a collapse of the Investment Banks does not bring down the Commercial Banks with their credit provision and payments system on which our society relies. Under current arrangements, Investment Banks, and Commercial Banks can be the same entity. The banks are betting their house against others and sometimes against their own customers in a manner that could collapse the whole financial system that underpins civilized life. In casinos, a better occasionally loses the shirt off their back. This occurred in 1988 with LTCM (US$4.6 billion), in 1995 with Barings for $1.2 billion, in 2008 with AIG for $18 billion, in 2008 with Societe Generale for 7.2 billion and in 2011 with UBS for $2 billion. The list continues to grow. Steven J. Williams wrote in 1999 that a 7% loss by Chase Manhattan Bank on its one-year derivative positions would wipe out their entire asset base. A loss of only 3% would wipe out the whole asset base of Chase Manhattan Bank. A 2% loss would wipe out the assets of JPMorgan. [2]

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

The situation has developed where almost all derivatives trading involves speculation for monetary gain whilst very little is done for the stability of business enterprises. As such almost all derivatives trading adds risk to the world in a dangerous manner. The magnitude of the derivatives trading now exceeds the total world production of goods and services by a factor of ten. The system is leveraged beyond comprehension. We are talking about a colossal exercise in folly that is doomed to fail. What we are witnessing is a casino betting system where the gamblers are banks. Greed has overtaken common sense and the vast fortunes to be made or lost feeds the insanity. Money obtains its value from the goods that can be exchanged with it. These derivatives transactions do not create any product or service. They simply transfer money from a loser to a winner. In that regard, they need gullible punters. These tend to be unsophisticated small time investors or dimwitted retirement managers or state and local government investors who are a sitting target for the sophisticated trading room operators. The derivatives trading, besides being risky to world finance, also drains nations, councils, states and citizens of their wealth and savings to put these ill-gotten gains in bank accounts of hoarders.

New Messiah says: “The derivatives system is utterly raving mad.”

We are talking about a financial folly on a global scale never before witnessed since humans invented the money token. The value of the money with which they are trading derives from the money transactions occurring in the real economy. Effectively, trillions of dollars of useless transactions are floated using money that is backed by the transactions in the real economy. The financial industry does not give value to money. It is the value of real goods that gives the value of money. Derivatives trading only moves money from rich people’s accounts to other rich people’s accounts. The whole financial exercise relies on the value imparted to money by the real economy that the financial industry has put in jeopardy. The financial industry will destroy their own nest by destroying the nest that gives value to the money with which they trade. The world as we know it will not collapse by nuclear Armageddon but by financial Armageddon. In reality, the nuclear Armageddon might be more survivable. According to financial author Bert Dohmen, a five percent drop in the value of derivatives is outside the ability of the world’s central banks to rescue.

In Australia, a Reserve Bank Bulletin reveals that Australian banks have more than $13 trillion in off-balance-sheet derivative exposures. This has risen from $5.4 trillion six years ago. If one percent of these evaporated because of a third party’s inability to pay, the shareholder wealth would also evaporate and the banks can be expected to declare bankruptcy.

In Australia, total bank assets are listed as $2 300 billion whilst they have exposure to $13 000 billion of derivatives positions. Of interest, Australia’s GDP is around $1 300 billion. Investment fund assets are $1 200 billion. The freely floated market capitalization of the stock market is $1 000 billion. [1]

The collapse would be sudden and brutal. Sudden means overnight. Overnight all money in bank accounts would be frozen or disappear. ATMs would cease to function. The government would cease to function in all countries that do not have a government owned public bank. When this derivatives bomb implodes, those that are used to living in third world conditions will fair reasonably well. The “developed” parts of the world will suffer immensely.

New Messiah says: “Protect yourselves with Glass-Steagall.”

New Messiah says: “Protect yourselves with a public bank.”

New Messiah says: “Ban derivatives.”

A serious question is whether derivatives should be allowed at all. There is very little benefit to mankind by the use of derivatives and that benefit could be provided by other means. in excess of ninety percent of all derivatives are held by the top seven U.S. banks. Ninety-nine percent of all reported derivatives are held by twenty-five of the largest banks. [2] These derivatives should simply be banned. Risk is created where none existed and is multiplied by leverage. All derivatives should be banned outright. The nature of the virtual money system is that the financial system could implode, leaving all bank account money worthless. Cash Currency would survive for a while longer. However, our food production system is now so remote from the cities that physical Cash Currency is just not going to feed the populous.

The system nearly collapsed the world money system in 2008 and the situation has got significantly worse. It will collapse more comprehensively if we do not do something about it.

New Messiah says: “Ban short-selling.”
  You may only sell what you own.

The practice of short selling occurs where someone sells something that one does not own. The seller quickly purchases the item just in time to pass ownership to the purchaser. The seller hopes to make money from money by the price change or the item that he does not yet own. This is evil of the worst kind. This is pure speculation with the aim of ‘making money from money’. The practice is rife in the financial industry and should be banned outright.

As a prelude to an outright ban on derivatives trading, banks should be prevented from trading in derivatives and putting their capital at risk. There used to be a system, called Glass-Steagall, that stopped this. The Glass-Steagall rules were repealed. In 1999, Bill Clinton signed the Gramm-Leach-Bliley Act. This allowed insurance, investment banking, and commercial banking to merge. The Commodity Futures Modernization Act then permitted unregulated commodity and derivatives trading.

A derivative is an instrument that invites money to change hands at some certain time in the future depending on some whimsical condition. Some of these can be tied to each other giving a daisy chain effect. The result is that a change in the weather could change a number of factors in unpredictable ways to bring the whole system of virtual money to collapse. A series of small collapses could cause a contagion causing a series of larger collapses leading to a total collapse. The fireworks factory is safe until someone strikes a match. The jumping jacks set off the Catherine wheels that set off the rockets that sets the town on fire. A small handful of companies represent a massive portion of all the derivatives traded around the world. If one of them goes bankrupt, the chain reaction would likely cause the others to fail for it is very unlikely that they would know who owes what to who and what is worth what. A derivative relies on the creditworthiness of the participants. If a major party goes belly up, then all derivatives in that entities name become worthless. These are held by other entities that have doubtful liquidity. A few worthless derivatives could put this company into bankruptcy causing another set of derivatives become worthless. Before long you have a nuclear style chain reaction where almost all derivatives become worthless. The result is that all large banks become bankrupt. How long this will take is not clear. It takes time to evaluate a companies holdings of derivatives and their value. One does not just make a phone call to another bank and ask: “Are your derivatives still worth anything?” This rapid chain reaction would firstly wipe the derivative values from all banks, then bankrupt the banks. All clients virtual account money would evaporate and there would be a wipe out of the entire financial system. This may occur before breakfast or it might take a week. I cannot be sure. It will be swift and devastating particularly for the highly organized west.

On 15 September 2008, the collapse of Lehman Brothers nearly caused a chain reaction that came close to collapsing the world financial system. The financial system virtually froze up. Following the collapse, entities were feared to deal with big banks because they were unsure how much exposure they had to the risky derivatives. It was difficult to evaluate a particular bank’s risk to toxic derivative trading. Banks avoided lending or trading with other banks. All the big banks had exposed themselves to risky derivative betting. Even the banks could not tell what other financial institutions might implode. With the world financial system at stake, the banks can demand that they get bailed out to ‘save the world from a financial collapse’. A collapse that they had precipitated. An extraordinary intervention by various government-influenced-agencies appears to have saved the day. But it was a close-run thing. Yet again, the U.S. ‘unfunded liabilities’ are now larger than the entire global economy. The derivatives market is around twenty times the magnitude of the total global economy. We are no longer talking billions. We are no longer talking trillions. We are now talking quadrillions. $1 000 000 000 000 000 is an awful lot of money to have swilling around in an unregulated system outside the jurisdiction of government. Any talk of fixing the ‘too big to fail’ problem have gone nowhere because the government does not control Wall Street. Wall Street controls the government. The ‘too big to fail’ banks have got forty percent bigger. [3] Around 1400 smaller banks have been closed or have been taken over by the big banks. [3] Michael Snyder claims that the ‘too big to fail’ banks have exposure to derivatives that is greater than twenty-eight times the magnitude of their total assets.[3] He also claims that the top five banks each have an exposure to derivatives that is twice the size of the U.S. national debt. It is time to break up the big banks.

The derivatives system effectively makes the citizens of the world pay tribute to the besuited financial scalpers in an environment that inappropriately worships the wealthy for their ‘genius’. This is a system that has created the largest bubble in financial history on money which is backed by the GDP of the nations. It is a bubble created on money itself which is backed only by the labors of the truly productive working people of the world. This bubble is effectively guaranteed to collapse. Unless we insulate ourselves from this, our money will become worthless. The collapse of U.S. economy will happen. Its timing and manner are yet to be determined. The big banks are effectively holding the citizens to ransom with a threat of financial Armageddon if they don’t get to control the system. The control of the situation is a matter of national security. To regulate the derivatives we are talking about a battle with powerful interests. Reports suggest that banks don’t monitor their derivatives risk effectively and cannot give appropriate information to regulators. The worry is not the vest-wearing terrorists but financial terrorists putting national money system under duress. One of my biggest worries is that the dismantling will actually cause the collapse. The vast hoards held by the financial terrorists might spill into the real economy precipitating a hyperinflationary event as they try to purchase real products and assets in a spending frenzy.

Not To Worry.

Not to worry. The TV tells us that everything is ok.

Media distortions
Just checking.

Have you done that websearch for me?

 This websearch is important: “why are derivatives dangerous”.