What are derivatives

What Are Derivatives And How Do They Threaten The Economy?

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Risky derivatives trading, which threatened to collapse the world economy in 2008, is still commonplace, and becoming increasingly so after a loosening of regulations.

The use of derivatives by financial institutions has created an ideological rift of sorts. While some herald derivatives as a practical and necessary way of transferring risk, others warn of their potential to cause global calamity.

But what exactly are they?

What are derivatives and how do banks use them?

As discussed in a previous piece, derivatives are “a financial contract whose value is derived from the performance of underlying market factors.” The specific assets which derivatives are based on can include bonds, securities, interest rates, market indexes, stocks, etc.

By trading such contracts, big banks have helped create a monstrous derivatives market thats current notional value (total value of assets) stands at around 710 trillion dollars (more than ten times the size of the world’s economy).

But despite their current size and impact, derivatives started rather inauspiciously. According to finance professor Don Chance, derivatives as we know them today started as little more than contracts for grain (pdf).

These contracts offered farmers a way around the extremely fluctuant prices of grain through setting contracts which guaranteed their supply for a fixed price at a later date.

In essence farmers were wagering that the prices of grain would go up (making their fixed price a bargain) whereas suppliers were wagering that they would go down (making the fixed price profitable for the suppliers).

These same bets happen today, granted at a much larger scale and with exponentially less transparency.

There are three basic types of derivative contracts to know:

  • Option – in this type of contract the buyer makes a bet on whether the derivatives financial instrument (whether it be a security or another financial asset) will either increase or decrease in value.
  • Swaps – wherein traders exchange one security for another. This type of contract has grown to encompass currency swaps and also interest rate swaps.
  • Forward contract – these contracts dictate that an asset will be sold at a future date for a specified price. They are often used to hedge risk and are traded over-the-counter (OTC) meaning there is no formal exchange.

Big banks have engaged in a multitude of OTC derivative trading in attempt to both shield themselves from risk (hedging) and to turn a profit.

In 2008, one type of derivative in particular was responsible for bringing down insurance giant AIG and nearly setting off a full on economic crash. This type of contract is called the credit default swap (CDS).

According to Investopedia, a CDS is a derivative meant to transfer credit exposure between two parties. In essence CDS’ are used as insurance against non-payment of loans.

In this exchange, the buyer is speculating that a third party loan will default, and conversely the seller is paid a fee until the predetermined maturity date of the CDS. If the third party defaults, the seller is responsible for paying off the remaining debt.

AIG was the biggest seller of CDS when the 2008 mortgage crisis hit and millions defaulted on their mortgages, making them liable for billions of dollars of defaulted loan debt.

Why are derivatives so dangerous and where are we now?

The risks of trading derivatives can often be dire, made evident throughout history (pdf) and around the world.

Below are three aspects which make derivatives particularly scary:

  • The market’s sizewith a total valuation of over $700 trillion–even if just a small percentage of such contracts go awry– derivatives have the potential to impact global markets drastically by setting off a chain reaction of debt.
  • Lack of transparency – this applies most directly to OTC trades which are made sans exchanges and with little regulation. Without oversight, it is impossible to track what derivative deals are being done and therefore nearly impossible to assess their size, breadth, and therefore risk.
  • Systematic riskby definition, systematic risk in regard to finance, means simply a specific type of risk that threatens an entire financial system as opposed to a singular entity. Systematic risk is created by derivatives when one “bet” or contract is linked to another, causing ripple effects when one contract goes awry.

Aside from Dodd Frank (pdf), banks’ derivative trading since 2008 has gone mostly unfettered throughout history, and in some cases has even been expanded.

Financial experts like Mike Patton believe that we are headed towards the next financial collapse–one that could prove to be even worse than 2008.

In this version, however, losses are felt globally, and on a much grander scale. Just as before, taxpayers are left holding the bag, but this time–since many are still struggling with the aftereffects of 2008–things could get much uglier.

A 2014 budget bill has gutted a number of provisions instituted in 2008 meant to prevent banks from taking on economy-threatening risk in addition to making taxpayers liable for losses on high-risk trading.

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James Pero