Economy Headline — 13 July 2013
A Criticism of Derivatives

Idries de Vries 

There can be no debate that derivatives are amongst root causes for the Global Financial Crisis of 2007 – 2008, arguably the worst economic crisis since the Great Depression that has kept most of the western economies in a state of recession for 6 years now.

This crisis came in to the public eye, namely, when on the 15th of September 2008 the American investment bank Lehman Brothers declared bankruptcy after realizing its trading positions on the derivatives market had caused losses it was unable to bear [1], following which the governments and central banks of the Unites States and Europe rushed to intervene in the derivatives markets, bailing out the big derivatives players on both sides of the Atlantic with trillions of dollars [2], to prevent whole scale economic breakdown.

The research that since 2008 has been undertaken to investigate the exact role of derivatives in the economic crisis has also proven they, specifically Credit Default Swaps (CDS) linked to sub-prime Collateralized Debt Obligations (CDO), were a root cause for it. [3]

However, a majority of economists and economic policy makers today believe that what really caused the crisis was not derivative trading per se, but more a lack of government oversights and control over this activity. Unscrupulous people – the so called “greedy bankers” – are said to have taken advantage of this situation, much to their own benefit but ultimately with disastrous outcomes for the economy as a whole. [4] Amongst mainstream economists and policy makers derivatives therefore continue to be seen a “potential source of good”, the trading in which just needs to be brought under control and organized correctly.

This article intends to investigate how correct this generally accepted point of view regarding derivatives is.

 

The theory of derivatives

The most common types of derivatives are forwards, futures, options and swaps. Forwards and futures are in essence the same and they organize a “purchase and sale” of an asset at a specified moment in the future, at a pre-agreed price. Option contracts provide an economic actor with the right – not the obligation! – to either buy or sell at or until a specified moment in the future, a specified quantity of an asset, at a pre-agreed price. If the option contract establishes a right to buy it is called a call-option, whereas if it establishes a right to sell it is called a put-option. Swaps are used to exchange cash flows. In an interest swap, for example, a bank that owns a fixed-rate mortgage trades the interests payments it is set to receive for the interest payments another bank is set to receive on a variable-rate mortgage. In an exchange rate swap a trader trades a delayed payment in euros he is set to receive for a delayed payment in dollars another trader is set to receive. And if an owner of debt decides to insure himself against the risk of the debtor defaulting on the loan, in other words if he comes to an agreement with a third party that he will pay the third party a fixed monthly sum in return for which the third party will pay back the amount of the loan in case the debtor does not, then the resulting agreement is called a credit default swap.

Capitalist economic theory justifies derivatives such as these by saying that they enable management of the risks natural in the trade of goods and services. Using derivatives a trader can guarantee for himself a sale at a particular price or a purchase at a particular price, and he can also guarantee for himself payment or receipt of a fixed amount although the trade contract itself might not guarantee him this. Since anything that reduces the risks in trade increases the willingness of people to engage in trade, capitalist economic theory holds that derivatives are promoters of economic activity.

Also, capitalist economic theory also argues that derivatives support liquidity in the marketplace and thereby support the price mechanism to develop the correct prices. This is because derivatives are usually much cheaper to buy than the assets they are derived from. For example, a barrel of crude oil costs around $100 so trading 1,000 barrels requires a starting capital of at $100,000. An option to sell 1,000 barrels of crude oil at a pre-agreed price costs only a fraction of the value that 1,000 barrels of crude oil represents, however, and can also be traded. Trading through options is therefore much more accessible, which according to capitalist economic theory will invite more participants to enter the market, thereby increasing competition which ensures prices always reflect the actual supply and demand balance.

 

The conflict between capitalist theory and the reality of derivative trading

There is ample evidence that in reality derivate trading does not take place to manage the risk natural in the trade of goods and services.

According to the Bank for International Settlement (BIS), the “central bank for central banks” based in Basel, Switzerland, the over-the-counter (OTC) trade in derivatives is worth some 600 trillion USD dollars annually. [5] In comparison, the value of all goods and services traded in the world is estimated to be around 70 trillion USD dollars annually. [6] Furthermore, in the Unites States, which hosts the largest derivatives market in the world, most derivatives are held by banks and financial institutions rather than institutions involved in trading goods and services. As per the end of 2011 96% of derivatives was in the hands of the 5 largest American banks, while the largest 25 American banks held nearly 100%. [7] It is quite rare, even, for derivative contracts to be settled through actual delivery of the asset at the pre-agreed price. At Eurex, the derivatives market for Germany and Switzerland, some 98% of derivative contracts are settled through a cash payment by the loser in the deal to the winner. [8]

All this means that derivatives are not primarily used by the producers and consumers of goods and services. They are not traded to manage the risks associated with trading goods and services, therefore. They are traded by speculators, the one who does not wish to engage in the trade of goods and services but wishes to benefit from the trades others engage in.

Derivatives also do not really help to ensure the prices for goods and services reflect the actual supply and demand balance, although they increase liquidity in the marketplace.

In a market without speculators the only participants are producers, consumers and the traditional traders who supply essential services to the market that add value. For example, a traditional trader facilitates trade in cases where the producers and consumers are not aware of each other’s existence; or he organizes transport to bring together producers and consumers from different geographical locations; or he organizes storage to bring together the production of producers and the consumption of consumers although these take place in different time periods; et cetera. In such a market any trade informs about the state of supply and demand because producers, consumers and traditional traders all act on the basis of actual supply and demand.

The speculators that dominate derivative trading, however, do not participate in the actual production, consumption or trading of goods and services, nor do they have any intention of doing so in the future. By definition, therefore, their trading on the marketplace can not provide any information about actual supply and demand because speculators are not engaged in this. Speculators act on the basis of what they have learned about producers, consumers and traditional traders. It is based on knowledge derived from producers, consumers and traditional traders, and this derived knowledge might be in complete alignment with the knowledge of producers, consumers and traditional traders, or it may not be. So the trades that speculators engage in may confirm the information about the state of supply and demand that results from trades done by producers, consumers and traditional traders, or it may go against it.

And this means that the liquidity that derivatives bring to a market actually obscures the information about the state of supply and demand that can be found in the marketplace, because this additional money is mostly from speculators whose trades add to the market both correct and incorrect information about actual supply and demand.

 

The problem with derivatives

Firstly, it has been shown that derivative trading influences the prices for goods and services on the market. [9] Since by far most derivative trading is done by speculators, this effectively means that those who do not produce or consume any goods or services, nor facilitate the coming together of production and consumption, nor have any desire to take up one of these roles in the marketplace, do have a say about what the prices for goods and services will be. This is an obstruction to efficient working of the price mechanism.

The process of price setting is of fundamental importance to an economy. If prices are free to fluctuate in response to changes in supply and demand, then price changes will inform the market participants of changes in producer supply and consumer preferences. This enables producers to make conscious decisions about how to utilize their productive assets, and consumers to make conscious decisions about how to utilize their income, the consequence of which will be that supply and demand are aligned and shortages and surpluses are removed from the market. Once prices become influenced by things other than supply and demand, such as laws, taxes or subsidies, producers and consumers will be misinformed by the prices in the economy. Consequently, the shortages and surpluses that are effectively expressions of waste will appear in the economy. Since derivative trading influences the prices in the economy, and since derivative trading is done by speculators rather than producers, consumers or value adding traders, its influence on prices is of the same kind as that of laws, taxes and subsidies. Derivative trading causes a sub-optimal allocation of productive assets in the economy and leads to the waste of shortages and surpluses.

Secondly, derivative trading increases the risk natural in enterprise and thereby holds back economic development.

The entrepreneurial spirit is the origin of all economic development. A reduction in the risk of doing business motivates the entrepreneurial spirit while an increase discourages it. Derivative trading increases the complexity of the market because it is an additional influence on the prices, next to supply and demand. It is therefore an addition to the uncertainty any (potential) entrepreneur faces and as such discourages the entrepreneurial spirit.

Fourthly, since derivatives do not really cancel the risks natural in the trade of goods and services but rather relocate them, derivative trading sets an economy on the path to economic crisis.

This is because derivative trading increases the overall risk in an economy through inducing excessive risk taking. As an example of this, in the build-up to the current economic crisis American banks were motivated to lend money without being properly considerate of the ability of the borrowers to repay, because through derivatives the rights to loan repayment and interest could be sold for a profit on the financial markets. In other words, handing out a loan was almost risk-free from the perspective of the banks since they sold the loan off to others immediately following the signing of the contract. [10]

It is also because derivative trading makes the identification and consequently the evaluation and tracking of the overall risks exposure of an economy an essentially impossible tasks. In the build to the current economic crisis the institutions that through derivatives took on the risk of default associated with loans developed derivatives to transfer on (part of) this risk to a further participant on the derivatives market. Such practices lead to the situation where none of the participants in the market really knows anymore where the risk has gone, or how much risk exactly a participant in the market has taken on. [11]

As an indication of just how unclear derivatives make the state of risk in an economy, during a speech in May 2007 Timothy Geithner, who then headed the Federal Reserve of New York, praised the development of derivatives for improving “the capacity to measure and manage risk”. [12] This was just weeks before the start of the Global Financial Crisis which around the world lead to economic contraction, mass unemployment, and even brought entire nations to the brink of collapse!

 

Conclusions

The analysis of the facts regarding derivatives shows that they impact an economy in various detrimental ways. It can be argued that they can also provide a benefit to an economy. However, the detriments of derivatives such as the obstruction of the price mechanism and the discouragement of entrepreneurship very clearly outweigh the potential benefit of relocating risk – also because the ability to relocate risks is a risk to an economy in and of itself, as explained above.

In light of the fact that derivatives have nevertheless become the norm in the global economy, the question should be asked why capitalist economy theory has had essentially no appreciation of the detriments of derivatives, and focused its discourse regarding them solely on their few potential benefits.

This would bring the discussion to the fundamentals that at this stage of the development of human society really should be discussed. The answer to the question is, namely, “because powerful institutions in the western world benefit from derivative trading tremendously”.

Derivatives, what they have caused in the world and what they continue to cause in the world, are therefore nothing but a symptom of a much more fundamental issue facing the world today, which is that the benefits of a few in this world trump the benefits of the masses and even the whole of this world.

 

Idries de Vries is an economist who writes on economics and geopolitics for various publications.

 


 

[1] “Causes of Collapse: The Failure of Lehman Brothers Holdings, Inc.”, Sawyer D. Duncan, University of Georgia, 2012, http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2192284

 

[2] “$29,000,000,000,000: A Detailed Look at the Fed’s Bailout by Funding Facility and Recipient”, James Felkerson, Levy Economics Institute – University of Missouri, 2011, www.levyinstitute.org/pubs/wp_698.pdf

 

[3] See for example “Credit Default Swaps and the Financial Crisis”, Michael Mirochnik, Columbia University, 2010, http://academiccommons.columbia.edu/catalog/ac:138122

 

[4] “The Role of Derivatives in the Financial Crisis”, Michael Greenberger, testimony to the Financial Crisis Inquiry Commission, 2010, http://fcic-static.law.stanford.edu/cdn_media/fcic-testimony/2010-0630-Greenberger.pdf

 

[5] “Semiannual OTC derivatives statistics at end-December 2012”, Bank for International Settlements, www.bis.org/statistics/derstats.htm

 

[6] http://en.wikipedia.org/wiki/World_economy

 

[7] “OCC Reports Fourth Quarter Trading Revenue of $2.5 Billion”, Office of the Comptroller of the Currency (OCC), 2012, http://occ.gov/news-issuances/news-releases/2012/nr-occ-2012-48.html

 

[8] “The Global Derivatives Market: An Introduction”, Stefan Mai, Deutsche Börse Group, 2008, www.math.nyu.edu/faculty/avellane/global_derivatives_market.pdf

 

[9] “The influence of financial  derivatives in global  commodity markets”, Accenture, 2008, www.accenture.com/SiteCollectionDocuments/PDF/Accenture_The_Influence_of_Financial_Derivatives_in_Global_Commodity_Markets.pdf

 

[10] “Confessions of a Subprime Lender: An Insider’s Tale of Greed, Fraud, and Ignorance”, Richard Bitner, 2009

 

[11] “How AIG fell apart”, Reuters, www.reuters.com/article/2008/09/18/us-how-aig-fell-apart-idUSMAR85972720080918

 

[12] “Liquidity Risk and the Global Economy”, Timothy Geithner, 2007, www.ny.frb.org/newsevents/speeches/2007/gei070515.html

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  1. The main problem is not just about derivates… The economic crisis doesn’t seem to be going anywhere, anytime soon making it ever more difficult for families to make ends meet and suffocating funds for public administration. Our leaders need to contact the specialists in the economic crisis, like the ones at the Orlando Bisegna Index and find out how they have helped a lot of counties with debt problems, business closures, and unemployment improving the economic situation for many families in addition to measuring the crisis itself.

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