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Wednesday, March 27, 2013

Derivatives as Weapons of Mass Destruction: An Explanation for non-Economists

Weapons of mass destruction exist in the financial sector. They are called derivatives.  Here is a simple explanation of what they are written by ex-central bankers.  You should care, as they may destroy the financial system as we know it and all of us will be hurt. 

No one really knows how much damage could be done by an unwinding in the derivatives market, but the total exposure (potential losses) may be as high as 700 Trillion dollars (yes that is with a T).  JP Morgan alone may have as much as $90 trillion exposure.  Other financial institutions such as Goldman Sachs, Citigroup, RBS , UBS and RBC all have large exposures.

What the Heck is a Derivative? 

Tough question to explain, but here is a simple example.  

Farmers are planting wheat in the spring. They do not know what success they will have this year. Next to them is a flour mill which will grind their wheat.  Down the road is an investor, and he would like to make money off the wheat crop without doing work, but he is willing to take some financial risk.
The investor tells the flour mill the owner “It is only the spring, but I will give you money now in exchange for letting me control who uses your mill in the fall.”

The owner of the mill accepts the money, reasoning that he can make an average year’s profit for his mill off just this one investor, even if the crop fails completely. 

The crop is successful and the farmers arrive at the mill. The investor charges them to gain access to the mill and the mill grinds the wheat into flour.

The investor makes money by charging the farmers more than they would have paid the mill owner, but the investor now controls access to the mill for the season, so the farmers have no choice.

The investor made money not through his labour (the farmer) or by offering a service (the mill owner).   The investor derived his money (i.e. a derivative) by essentially betting that the price of wheat would stay high and the crop would be good.  If the crop had failed completely, the investor’s derivative would have failed and he would have lost all his money.

So, in economic terms, a derivative is a contract whose value is derived from the performance of underlying market factors, such as market securities, indices, interest rates or equity prices.  In this case, the underlying factor was the amount of wheat to be produced and its price which was not known in the spring of the year.

Can Derivatives be a Good Thing?

Yes.  Consider a medium sized trucking company that has just received a major contract for two years of shipping.  They are worried that they could lose money on the contract if the price of diesel fuel goes up suddenly. They approach an investor for a derivative.  The investor agrees to guarantee the price of fuel to the trucking company for the next two years. The price of the fuel will be higher than the current market price, but the trucking company believes they can still make a profit, even at the higher price, so this is good for them. The investor believes that the various rises and falls in diesel prices will allow him a profit. 
In this case, the trucking company has been able to outsource its risk (fuel price) to an investor in order to sign the contract with confidence.

Why did Derivatives Turned out to be Dangerous?

The key issue lies in the outsourcing of risk. An intelligent use of derivative can allow a business to outsource its risk. Unfortunately, the folks on Wall Street and in The City have found increasingly complex methods of using derivatives to outsource risk.  They believe that they can be almost risk free by covering all their investment risks with derivatives.

They have done this so much, there is now believed to be some 700 trillion dollars worth of derivative contracts out there – most of which are beyond the understanding of those who supposedly regulate finance markets. The risk involved is also beyond the understanding of the financial institutes involved.

The Killer

The financial institutes such as JP Morgan, UBS and CITI believe they have outsourced risk. But here is the killer. Everyone one of them is busy outsourcing risk by selling derivatives to other financial institutes. In other words, they are all outsourcing their risk to each other.  This is a closed loop with a finite amount of players. If everyone thinks they have outsourced their risk to everyone else, then they are collectively holding all the risk.  They are all vulnerable.
The end result is that the financial institutes that thought they were outsourcing risk may find they have to make payouts on the derivatives they bought and sold. The amount will exceed their resource levels and therefore they will go bust.  If there is another financial shock like the 2008 crisis, then the entire derivatives bubble may pop and the process will unwind on itself.

And then there are synthetic derivatives and synthetic derivatives combined with options trading, but might might be a story for another day.

Once again, we may  see the financial institutes lining up for more bailouts if this market unwinds.

This is economics for the rest of us. Financial derivatives should be seen as a weapon of mass destruction. 


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