THE ROLE OF DERIVATIVES

During the recent financial crises, you may have heard some talk about the role of derivatives. These mysterious financial instruments are understood by practically nobody. Not by those who sell them and not by those who buy them. Yet the survival of banking system and, ironically, the destruction of our entire economy may be the result of their trading.  The following brief essay by Chris Temple gives us a basic understanding of derivatives and an explanation of their importance. / GB


THE ROLE OF DERIVATIVES


The issue of derivatives is one which has received occasional mention in the mainstream media. Derivatives have also received more widespread attention among certain pundits purporting to know a thing or two about economics; the trouble here, though, is we hear little more than hysterical ravings about how derivatives are about to cause the end of the world. Little in the way of helpful or explanatory information is offered by these types to explain exactly what derivatives are, how they work, and what the benefits (and dangers) are to the economy.

Two preliminary things here, before I defer to a more qualified expert than I. First, we can simplify things by defining this important term. The root word of derivative is derive. Derivatives are financial instruments which are derived from some underlying commodity or asset. Most all of you have heard of an option before; this is a financial instrument giving you the option to buy or sell a certain security at a certain price, and by a certain date. Technically, an option itself is a derivative, as it is derived from and dependent on the fate of an underlying asset. So, if you keep this in mind, you’ll have an easier time in general understanding derivatives as just what they are; sophisticated "bets" on the fate of underlying stocks, bonds, interest rate levels, currencies, commodities and such.

The second thing to understand about derivatives is that their use has been critical to the continued life of our fractional reserve banking/credit system, and to the broader economy. All of you have read at least one version of my "signature" essay entitled Understanding the Game. In it, I explain how, over time, it has become necessary for the financial system to create ever more intricate--and inherently risky--devices to "create" wealth. Through the multiplication of these derivative contracts, as you’ll read in a moment, prices for many of the underlying assets have been artificially increased. This new "wealth" has served as the basis for ever more credit creation, merger deals and other means for keeping the rubber band stretching even more.

The trouble is, as even Fed Chairman Alan Greenspan (generally a fan of derivatives) has implied before, the wonderful wealth-creating attributes of derivatives could reverse one day. These very same instruments that have been responsible for the creation of trillions of dollars worth of enhanced values of underlying assets could indeed end up being indiscriminate destroyers of capital, were they to "unwind" in a significant way. This happened with Long Term Capital Management, a hedge fund collapse that nearly brought down the entire system. It happened with Enron; but regulators were on top of things sufficiently ahead of time to limit, for now, the ripple effects. They might not be so lucky next time.

For those of you who want to take the time to study the derivative issue further, I would strongly suggest visiting www.econstrat.com, which is the web site for the Derivatives Study Center. In scouring the Web myself for the most understandable explanations to pass along to you, the commentaries and "primer" by the Center’s Randall Dodd truly stood out.

In his "Derivatives Primer," Dodd--after discussing how these kinds of contracts in a broad sense aren’t exactly new--discusses the risks inherent in derivatives:

"The first danger posed by derivatives comes from the leverage they provide to both hedgers and speculators," he writes. "Derivatives allow investors to take a large price position in the market while committing only a small amount of capital--thus the use of their capital is leveraged. . ."

Back to the Long Term Capital story: some of you remember that this hedge fund had raised approximately $3 billion from investors. Yet, when LTCM blew up, it had "notional" (presumed face) value of derivatives of an astounding $1.4 trillion. This happened because LTCM milked derivative contracts’ ability to create artificial wealth for all they were worth. In the process--and this is one of the inflationary components of what derivatives do--the placing/creating of all these fancy "bets" skewed the values of underlying assets considerably.

Many of you know that if all of a sudden there is unusually large activity, let’s say, in the options for XYZ Company, the share price of that same company will be affected. If a number of options are suddenly being either created or bought betting that XYZ is going up, then the share price of the stock itself will usually go up, as investors think that "somebody knows something good is going to happen." Yet, this might not really be true; and it could be nothing more than the (at its core) unnatural effect of these kinds of derivative activity that give XYZ a falsely inflated value, and give investors similarly wrong expectations.

Using the LTCM example above, you can imagine the magnitude even now of still-inflated values in the financial markets courtesy of derivatives.

In his Primer, Dodd also bemoans the fact that further risks are presented due to the fact that many derivatives traded Over the Counter are mysterious. They are not regulated, nor is there much information available as to their quantity and character. Recently, Sen. Dianne Feinstein (D-CA) attempted to get legislation acted upon which would regulate these, the very same types of deals, it should be remembered, were engaged in by Enron. However, everyone from Fed Chairman Greenspan to Wall Street turned on the lobbying offensive, and her move was defeated. Thus, even after all the hand-wringing over Enron, it appears that the majority of legislators are perfectly willing to allow this ticking time bomb to exist.

Finishing up the commentary section of his primer, Dodd states, "In sum, the enormous derivatives markets are both useful and dangerous. Current methods of regulating these markets are not adequate to assure that the markets are safe and sound and that disruptions from these markets do not spill over into the broad economy."

No doubt this is an understatement; and the fact that Alan Greenspan, for his part, is unwilling to see this huge inflationary mechanism regulated--in spite of the risks--underscores just how unable he is without derivatives to keep the overall credit bubble and the dollar from deflating much further.

by Chris Temple / NationalInvestor.com