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 contracts 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 task. 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.
References
[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
[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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