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The Derivatives Markets

Try reading any of the leading academic finance journals—you will immediately be hit with an avalanche of equations. Why all the math? A major reason is derivatives, an astonishingly motley assortment of securities ranging from a simple promise to engage in a subsequent transaction to the most fiendishly complex package of contingent rights and obligations ever conceived by the human mind. Since the 1970s, we have witnessed a prodigious increase in the trading of derivatives, whether in the form of futures, forwards, options, and swaps. Associated with this has been an alteration in the culture of the financial markets. Derivatives involve sophisticated quantitative models to price them. That brought a cavalcade of engineers, physicists, and mathematicians to Wall Street. As a result, the financial markets have gone from being a place that held up intuition and prudence as the most admirable capacities to a place that increasingly prizes analysis and science.

Culture is not the only thing that derivatives have changed. The rise of derivatives has also had political repercussions. Derivatives are the most levered instruments in the financial universe. Should any large, well-connected player make a mistake or be reckless in their use of derivatives, it can adversely impact the stability of the financial system as a whole—obviously, something in which public officials inevitably take an interest as part of the modern democratic state’s role in managing the economy. Add to this leverage the complexity that derivatives embody. Less-schooled investors © The Author(s) 2017

G. Bragues, Money, Markets, and Democracy,

DOI 10.1057/978-1-137-56940-0_6

are left vulnerable to exploitation, particularly at the hands of those who create and market derivatives. Naturally, this stirs up traditional regulatory concerns regarding the maintenance of transactional fairness. By definition, too, the leverage that derivatives involve enables traders and investors to take a position on an asset with a smaller amount of capital. In this way, derivatives make it easier for speculative activity to take place that causes the prices of socially vital goods, like oil, to deviate from the underlying economic fundamentals. Indeed, that speculative activity can take prices toward levels that alter the geopolitical balance and spark political unrest.

Nowhere are the excesses of finance more evident than they are with derivatives. Yet nowhere are such excesses more commonly misunderstood. Warren Buffet’s famous rebuke of derivatives as “weapons of mass financial destruction”[1] surely overstates their systemic risks. No doubt, derivatives have done harm to society, but it cannot simply be chalked up to a mixture of financier greed and mathematical hubris. Some of this harm, as I shall endeavor to show with the options embedded in the CDOs related to the sub-prime mortgage crisis, was the product of a widespread forecast error made in pursuit of an otherwise risk-averse investment strategy. Some of this harm, though, has also been perpetrated by governments using derivatives to make their finances look better than they really are. Nor can derivatives be properly described as the main culprits for large swings in the prices of essential commodities. Granted, much of what passes for derivatives trading is no different from sports betting. But we cannot neglect the role of democracy in encouraging derivatives. Besides chipping away at the moral animus against gambling, democracy has advanced the cause of derivatives by its having removed the last vestiges of the gold standard in the early 1970s. By generating a heap of uncertainty and volatility, this transition to a pure fiat money regime is the chief reason why derivatives have grown from a small corner of the financial markets to a humungous block.

As risk management tools, however, derivatives are perfectly justifiable. They are suitable means of grappling with the perils and difficulties to which both nature and the requisites of social co-operation subject us. Their usefulness, however, becomes regrettable when the risks they are supposed to hedge against are unnecessarily generated by public policy— as indeed these have been within our democracies.

Usage frequency of “derivative security” in English Language Books, 1950-2000. Source

Fig. 6.1 Usage frequency of “derivative security” in English Language Books, 1950-2000. Source: Google Ngram

  • [1] Warren Buffet, “2002 Chairman’s Letter” in Berkshire Hathaway 2002 Annual Report, 15,http://www.berkshirehathaway.com/2003ar/2003ar.pdf
 
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