Derivatives: Weapons of mass destruction

For Adam Smith, “Goods can serve many other purposes besides purchasing money, but money can serve no other purpose besides purchasing goods.” (WoN 4.i).

Banks and financial traders have other ideas. They are now running a parallel economy – of larger size than the real economy – in which money makes money out of money. The salaries and bonuses in this parallel economy bear no relation to those in the real world and suggest that their mission can be summed up by the words of Gordon Gekko in the 1987 film Wall Street: “Greed, for lack of a better word, is good. Greed is right. Greed works. Greed clarifies, cuts through, and captures the essence of the evolutionary spirit.” The primary tools they have adopted for this new market are derivatives, which previously had a long history serving the trade in goods and services.

An investor would agree to buy a certain quantity of grain in six months for an agreed price. If the market price rises in the interim he makes a profit. If it drops he makes a loss. The investor, therefore, needed to know a lot about how the market had behaved in the past so that he had a reasonable chance of making a profit. It was useful for the farmer because he could sleep at night knowing that he had a guaranteed price for his crop. This is the simplest form of derivative. When used within the agricultural market this ‘future’ gave stability to the trade in food.

You can also arrange an option that gives you the right, though not the obligation, to buy or sell something on a specified date for a specified price, for example, by putting your name down for a car. For years futures and options were simply useful tools.

Derivatives deal in risk. An investor takes over risk from the farmer. If the risk is small his margin of profit or loss is also small; if great he can expect to make a larger profit if things go his way. The more risk a trader is prepared to take the greater profit or loss he is likely to make. Financiers only realised that derivatives could be applied to share dealings in the 1970s when they found mathematical ways to quantify probability and risk. They were dealing in very large quantities so it would be impossible to assess each transaction based on knowledge of a specific product. This is where the trade in derivatives left the real world of goods and services for the abstract world of the mathematician.

The process speeded up because you could instruct your computer to act on your behalf using algorithms that make deals in a fraction of a second, much faster than a human can react. Even if each deal is small the aggregate of tiny increases or losses, either to make a profit or to cover backsides, is worthwhile to the trader. If an asset of £10,000 passes between 10 traders, each hoping for profit or to cover loss, then about £100,000 of notional trade would take place in a short time. So market activity in this abstract world is vastly greater than the market for the assets themselves. No one knows how much greater because the trade is not regulated, but some estimate that the amount of money sloshing around the world each day is ten times the global GDP. The original purpose of the Tobin tax (the financial transaction tax) was not so much to make money from this activity as to slow it down. The details of the trade in derivatives are, of course, more complicated than described here: Ben Bernanke, now chair of the US Federal Reserve, once said that he did not understand how these funds worked but he had confidence in “sophisticated financial institutions” that did.

Traders have invented a number of financial instruments for making money out of money, short-selling being one of them. A short-seller may think that a company is over-valued. He borrows some of its shares at an agreed price. Then he sells them. Later he buys the same number of the same shares and gives them – returns them – to the lender. If in the meantime the shares drop in price, as expected, he makes a profit. (he sold at a high price later bought at a low price). If the shares rise, of course, he makes a loss. This sounds fairly innocuous but readers of The Fear Index by Robert Harris will appreciate how even shorts, a simple form of derivative, have the power to cause mayhem in global financial markets.

Naked-short-selling uses notional shares that the trader has not even borrowed. Having ‘sold’ them he hopes to buy the same number of shares at a lower price before he has to deliver certificates for the shares he had previously sold. In the real world, selling something you don’t have is the definition of fraud. Even worse, he can use this financial invention to manipulate the market. For example, if he pretends to own a large number of shares in a company and then ‘sells’ them, other traders might panic and start a wave of selling. The price would plummet and he would then buy shares at the lower price in order to deliver the certificates to those who had bought his notional shares (sell high, buy low). Naked short-selling is described by the US securities regulator (SEC) as a “particularly pernicious form of fraud.” Robert Shapiro, former US Undersecretary of Commerce, concluded in March 2008 that it had ruined 1,000 firms and wiped $100bn off share prices. It has been banned in the US, Japan, India, Australia and Hong Kong. Europe is in the process of banning it but the UK government is tying to derail this initiative. This is just one example of Britain’s adoption of the lowest possible standards in order to attract financial business, however disreputable, to London.

Another financial invention is called Credit Default Swaps (CDSs). The first CDS was between Exxon, JP Morgan and the European Bank (EBRD) over possible liability for the Exxon Valdess spillage in 1989, but it took months of negotiation. The bank, JP Morgan, appreciating the value of CDSs, devised a way of applying them over a large number of loans that had a risk of default. Rather than dealing with every loan on its merits it bundled them together – called securitisation – and transfered them to a shell company in a secrecy location (a Special-Purpose Vehicle, SPV) to assume $9.7bn of JPM’s default risks. By the law of averages the risk would be spread and the shell company could be marketed to investors. It would be a source of income for JPM and it would take capital off JPM’s books, thus neutering the Basle rule that for every $10 lent $1 should be retained as reserves (by 2007 banks only retained $1 for every $70 lent). The greatest benefit would be that shareholders of the shell company, not JPM, would cover the risk of default on JPM’s loans. JPM could then make loans that gave them no risk from default.

From the regulator’s point of view, risk was spread and therefore diminished, while liquidity and the money supply were increased. But few saw that CDSs would engulfed the whole financial system.

Collateral Debt Obligations (CDOs) are securitised loans bundled into collections – each with varying risk – that are sold to investors. The greater the risk the greater the premium the borrower has to pay when taking up a loan, and the greater the interest that can be paid to the investor. This is where sub-prime mortgages came in. With the long history of rising house prices the poor could easily be persuaded to take out maximum debt to buy a home. Securitised CDOs would transfer the risk of default to secrecy SPVs. This would mean that the bank would not need to worry about making loans to people with a high chance of defaulting, and their salesmen could sell irresponsibly. The SPVs would also take more capital off the bank’s books. CDSs would enable them to swap risks in a way that would be very hard for regulators to check. The result would be high-yield, though risky, investments based on money dragged out of poor people struggling to make their mortgage payments. Greed has no compassion. These high-interest investments were hugely popular around the world for those willing to accept risk for a high return. Lawrence Summers (who took the US out of the Kyoto process and led the abolition of the Glass-Steagall Act that had separated commercial from investment banks, prevented ‘too-big-to-fail’, and achieved stability for 60 years) said at the time he was Deputy Secretary to the Treasury, “The parties to these kinds of contract are largely sophisticated financial institutions that would appear to be eminently capable of protecting themselves from fraud”. We now know that CDOs, CDSs and SPVs were largely responsible for the 2008 crash: the poor, and not only the poor, lost their life’s savings, their jobs, their homes, and social services. And taxpayers bailed out the perpetrators. In 2009 Lawrence Summers was appointed President Obama’s director of the White House National Economic Council before returning to academia to mislead economists at Harvard.

The description ‘derivative’ should be taken at face value. It is a trade in money derived from the real world but not a part of it. The purpose is to manipulate anything that has a price tag in order to make money for the trader. These traders are parasites on society. However, the currency in this parallel universe is the same as that used for education and health, or for selling a house or buying a cabbage. The volume of this trade is ten times the volume of trade in goods and services, and traders extract money that other mortals can’t possibly aspire to. No wonder it causes havoc.

Reform is necessary. It is clear from this summary that the financial wizards will get round any regulations that have the slightest ambiguity. This suggests that retail banks must be returned to their role of lending money deposited by their customers, not ‘ring fenced’ from other parts of a bank. Investment banks must only invest in real business. And casino activities, that aim to create money out of money, must become a criminal activity.


Featured image: Chasing the markets. Author: T. Al Nakib. Source:

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