Financial Derivatives – The Next Crash Waiting to Happen

What is a financial derivative, why were they created and why should we be concerned about them?

Let’s start with why and how they were created.  In the 1990’s the risk management departments of our largest banks, with all the money and clients they had access to, felt there should be new and inventive way to make money.  They experimented with new types of investments beyond the traditional stocks, bonds and loans.  The primary form this took was inventing derivatives, investments derived from real investments.

The most popular form was called the credit-default swap and was the primary reason for the market crash in the Fall of 2008.  A credit-default swap occurs between two “counter parties” (could be an individual, bank, insurance company or a government); these parties are brought together by an intermediary (broker) within the bank.  The banks earn a commission by bringing the two counter parties together.  The counter parties negotiate a contract over essentially anything; it could be over the price of a stock on a certain date or the temperature in Iceland a month or 3 months from now.  The important point is that one party takes one side of the swap, for example party one believes that General Motors stock will be up $10 per share and the second party essentially bets the other side; believing the stock will be down $10 per share.   An expiration date is determined and something called the nominal amount is set, in other words what amount of money is going to be wagered on this contract anywhere from $10,000 to $10,000,000 or more.  Neither party has to put up any money, the nominal amount is simply set and is due to the winner from the loser on the expiration date of the contract.  No collateral is required.

The reason that this type of activity is so dangerous is because it is not regulated and has no transparency; no one has any idea from day to day how much money is being wagered.  As we saw in the fall of 2008, Lehman Brothers, a major brokerage firm, was involved in billions of dollars of this type of activity and when it failed it rocked the markets.  It required that the money that was wagered on the continued existence of Lehman brother was now due immediately and the participants, counter parties of which there were many, had to invade their stock and bond portfolios in order to come up with what they owed.

It should be obvious that this is not investing.  No benefit to society is created by these transactions, it is simply legalized gambling.  The size of derivative market is immense, it is 10 times the world GDP and the total dollar value involved in this market on any given is day is approximately 680 trillion dollars.

derivatives-graphic

Why are derivative so dangerous to the stability of the financial world?  Depending upon who wins and who loses on any given day, the results can continue to rock the financial markets.  We will have no warning just as we did not have any warning in 2008 because no one knows what is going on inside these derivative markets.  Attempts to regulate these markets have failed.  In fact, bankers like Richard Bookstaber who participated in developing derivatives, have testified before a senate sub-committee and recommend not that derivatives be regulated, but that instead they be outlawed.  They believe that regulation would only make derivatives more volatile and more unstable.

“Like many pessimistic observers, Richard Bookstaber thinks financial derivatives, Wall Street innovation, and hedge funds will lead to a financial meltdown.  What sets Mr. Bookstaber apart is that he has spent his career designing derivatives, working on Wall Street, and running a hedge fund”

–Wall Street Journal1

 

Derivatives are not the tail Wagging the dog, they are the dog.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Demon of our Own Design by Richard Bookstaber, back cover

 

 

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