Wild derivative geese

Derivatives markets, it seems, have become a popular scapegoat for the “financial crisis” recently. This is perhaps partly due to the fact that these markets are far less well understood than the securities market. Joe Sixpack can easily understand the idea of trading an apple for an orange, or money for shares, and can get his head around the idea of interest, dividends and yields without too much difficulty. However, since Joe probably doesn’t take out many derivatives contracts it might require a little more mental warmup on his part in order to get his head around these.

This needn’t be the case though since, although Joe might not trade futures or options, more than likely he has dealt with something that is very similar to a derivatives contract: the common mortgage. When the bank lends you money to buy a house, they’re taking a risk. They mitigates this risk by using the house that you purchase as collatoral against the loan so that if you are ever unable to pay back the mortgage they can take your house and sell it to recover their money. Additionally, since they might not be able to sell the house for the same price you purchased it for, they would typically ask you to provide a certain amount, up front, before they’ll be willing to lend you the rest. If they felt the price of your house could potentially drop by as much as 20% then it would be logical for them to require you to provide at least 20% of the funds required to purchase the house before they would agree to lend you the remaining 80%.

A derivatives contract is much the same as a mortage. Essentially you want to purchase something (let’s say $1000 worth of gold) and you only have $100. As such, you need to borrow the remaining $900 from a trading desk or a bank or someone. Once again, whoever lends you that money is taking a risk since if you’re not able to pay it back and the price of gold drops then they may not be able to recover their $900 by selling the gold you purchased. This is an example of a margin contract and the $100 that you put up initially is what’s called the margin (the equivallent of a down payment on a house). The way the lender deals with this situation (and thus mitigates their risk) is by saying that if the price of gold drops by 10% then this will trigger a margin call – basically you have to cough up more money or they will close the contract that you had (i.e. sell your gold), recover their $900 and call it a day.

Now, what’s interesting is not really the mortgage or the derivatives contracts themselves. These are both, quite simply, loan agreements which serve an invaluable role in the economy. Nor are the measures that lenders take to mitigate their risks very interesting to anyone except the lenders, since it is only the lenders that stand to loose anything. If Air Tahiti and Exxon Mobil both take out a futures contract on petrol, with Air Tahiti borrowing the money required to take out such a contract from Murry Rothbard and Exon borrowing from Ludwig von Mises, in the event that Air Tahiti made massive losses and went bust the effect on the global financial system would be minimal – only Murry Rothbard stands to loose his money here and, even then, only if he did a shoddy job of drafting up or executing the futures contract that he made with Air Tahiti. If the markets shift against Air Tahiti then, under normal conditions, Murry would close their futures position on petrol and the money that Air Tahiti fronted initially should cover any losses.

What’s interesting is what is being referred to in the media as counter party failure… a euphimism if ever I saw one (but then virtually all terminology used in the banking industry is). What counter party failur concerns is the instance where Murry Rothbard goes broke and isn’t to provide the cash necessary to purchase the petrol from Exon Mobil on the date agreed upon in the futures contract. However, this is rather a peculiar event. How could Murry Rothbard loose the money that he had already lent to Air Tahiti? Air Tahiti used that money to purchase a futures contract… so what is Murry Rothbard still doing with it? It appears that Rothbard has pretended to lend the money to Air Tahiti whilst simultaneously spending it on something else (e.g. housing in California).
In this particular case, this is not plausible because Murry Rothbard is not a bank and banks are the only institutions in the world that are allowed, by law, to create false certificates of deposit and lend out the same set of funds multiple times under a system known as Fractional Reserve Banking. So the root cause of the problem is quite simply that the banks maintain anything less than 100% reserves. Had the banks that lent money to derivatives traders (so that these people could take out margins, futures and options contracts) maintained 100% reserves then neither the failure of any one nor of any large group of derivatives traders would have had any serious impact on the tax payers in the US or anywhere else in the world… for if banks held 100% reserves then the money that was leant to Air Tahiti would never go anywhere – it would stay locked into that contract until the contract terminated… only ever to be used for that one thing. It would be almost impossible for either Air Tahiti or Exon Mobil to ever be in a position not to live up to the conditions of the futures contract or for money to “dissapear” from the system.
The problem then is, as always (and neither the banks nor the governments want to admit it even in the very rare instances when one or two of their employees are aware of it) that the creation of false certificates of deposit in the money industry is not called embezzelment as it is called in other industries that deal with fungible goods (such as the grain industry), but instead has been legalised and given a different name: Fractional Reserve Banking (FRB). The underlying leverage which is the true danger to the system comes not from the derivatives contracts but from the FRB system that allows banks to lend out $100 on the back of $3 is deposits (3% being the average amount of reserves that most banks around the world keep). Banks, which most people incredibly think of as safe little deposit institutions, are leveraging your deposits 30 to 1 – some of the highest levels of risk around. For your trouble (and the risk you take) here in Europe a depositor cannot even expect to be paid enough interest to cover inflation – you won’t even earn 3% interest for having implicitly made one of the most risky investments that it is possible to make by the simple act of depositing your money at UBS or Deutch Bank.
FRB has existed pretty much ever since the invention of money and loans but this was usually kept in check by the fear of a bank run. Banks that maintained insufficient reserves were always at risk of a run on their reserves (which historically were held in gold). In particular, banks were vulnerable because their competitors (other banks) knew this fact and could call in on loans in unison if they thought they might be able to get rid of a competitor in the market in doing so. However when all banks started to create false certificates, Bank B was actually placed at some risk by the reckless lending on the part of Bank A because a run on Bank A could provoke a wider lack of faith in the banking institutions and hence a run on Bank B’s deposits as well. If Bank B maintained 100% reserves then this probably wouldn’t bother them and they’d see a run on Bank A as a convenient opportunity to eliminate Bank A from the market. However if Bank B also had less than 100% reserves then Bank As problems became the problems of Bank B…
This “interdependence” of banks led to the formation of various cartels over the ages (such as the Ricci family in Florence in the second half of the sixteenth century) who would coordinate their efforts by agreeing upon “production levels” much as OPEC does with petrol – only the “production levels” for the members of these banking cartels were to determine the rates at which each bank could create false certificates of deposit (i.e. their reserve requirement). All of these cartels inevitably collapsed eventually due to free market forces. Even when banks were able to coordinate their inflation nationally they were at risk because of payments that had to be settled, in specie, internationally.
It was not until the invention of the central bank and the implementation of a “lender of last resort” that implicitly backed the reckless lending practices of banks through the use of tax payer’s money that banks really got free reign to wreak havoc. And even then, for many years the central banks themselves were kept in check once again because international settlements had to be made in gold. Only with the bankruptcy of the United States in the late 1970s and the complete abandonment of any tangible asset to be used as reserves – the abandonment of the gold standard – were the doors opened for banks to make the kind of losses that they are making today by creating money out of thin air with absolutely no constraint on their ability to do so. The existence of the central bank as a lender of last resort only exacerbates the problem since people continue to think of banks (inherently inefficient loss making institutions – even their profits are made primarily by way of inflation) as safe deposit institutions. If the full extent of the risk associated with putting your money in deposit accounts at the local bank was allowed to be felt then people would stop putting their money in banks that used it on investments that were leveraged 30 to 1. They’d start demanding the people that housed their money maintained 80% or 100% reserves (depending on how much “risk” they wanted to take on their deposits) and withing 20 to 30 years the problem would go away once and for all – not due to any miraculous government regulation but, as usual, because the invisible hard of the free market would sort it out.
In short, the derivatives industry is a scape goat. It is not the fundamental cause of the current financial woes and nor is the root cause being addressed in any way (or even so much as discussed) in the mainstream media.

PS: For further information about the history of money and banking see Murry Rothbard’s The Case Against the Fed.