Derivatives comprise an estimated US$300 of the global US$400 trillion financial bubble. They may be considerably more, and the $400 trillion figure may be too low. No one knows for sure, because, like Enron’s secret deals off the books (and Enron was a pioneer in the use of derivatives), there is no centralised accounting of derivatives even within nations, let alone globally. The textbook definition of a derivative, is a financial instrument, the value of which is based on the value or values of one or more underlying assets or indexes of assets. Derivatives can be based on equities (shares), debt (bonds, bills, and notes), currencies, and even indexes of these various things, such as the Dow Jones Industrial Average. Derivatives are sold and traded either on a regulated exchange, such as the Chicago Board of Trade, or the Australian Stock Exchange or the SFE Corporation in Australia, one of the largest derivatives exchanges by volume in Asia, or off the exchanges, directly between the different counterparties (banks, insurance companies, hedge funds, etc.), which is known as “over-the-counter” (OTC). Allegedly, the purpose of derivatives is to reduce the risk inherent in fluctuations of foreign exchange rates, interest rates, and market prices. In fact, derivatives
are the risk, and have played a crucial role in destroying the world’s physical economy.
A generation or so ago, when people still thought in terms of the real, physical economy, the essence of derivatives would have been clear: it is the difference between investment (related, ultimately, to the actual physical economy), on the one hand, and gambling or speculation, on the other.
The instruments which "underlie" derivatives—shares, bonds, commodities, money—represent a claim, usually through ownership, on wealth produced in the real physical economy. Such claims can be purchased. Thus, shares in a company can be bought, as can bonds issued by governments or corporations, or hard commodities produced by agriculture, forest industries, or minerals extractors and refiners.
The instrument so purchased provides a means by which the wealth produced may be turned into money. In the case of shares, this may take the form of the company’s dividend payment, the part of after-tax profits distributed to shareholders, or it might take the form of capital gains realized through the appreciation of the shares’ value. Formerly, such monetisation, or potential for monetisation, would have been more or less directly related to the economic performance of the company, in contributing to an increasing overall rate of wealth generation through productivity-enhancing increases in the powers of labor. So, too, are bonds directly related to economic activity, though where shares represent equity ownership, bonds represent indebtedness. The interest paid corresponds, more or less, to the dividend yield of a share. And, like shares, bonds can provide capital appreciation.
A generation ago, such financial instruments were the means for transforming economic surplus into monetised net profit. “Hard” commodities (upon which derivatives may also be based) are different: they are bought and sold so that production might proceed. Recognising the danger in gambling-style speculation on commodities, options in agricultural commodities were banned in the U.S. in 1938 under President Franklin Roosevelt, and were not legalised again until 1983, under financial deregulation.
Purchases of shares and bonds would once have been seen as investments for the long haul. Trade in commodities would have been seen not as investment, but as purchases and sales.
It’s all gambling
With derivatives, we move from investment, and the purchase and sale of hard commodities, to pure speculation on the future price or yield performance of what were once investments, and relatively simple, economically necessary transactions.
All derivatives are actually variations on futures trading, and, much as some insist to the contrary, all futures trading is inherently speculation or gambling. Thus until late in 1989, all futures trading, of any sort, was outlawed in Germany, under the country’s gambling laws. Such activities were not treated as a legitimate part of business activity, just as, back in the days when society was much more sane, gambling itself used to be seen as an asocial, harmful activity. In fact, in 1993, when the CEC campaigned in Parliament and elsewhere against derivatives, the Australian Securities Commission, the nation’s corporate watchdog, issued a draft report warning that criminal sanctions for illegal gambling could well be applied against the big derivatives players such as Westpac Bank, the Australian Wheat Board, Bankers Trust Australia, Macquarie Bank and others. Advice provided by the huge corporate legal firm of Mallesons Stephen Jacques to their clients in April 1993, warned that most derivatives trading in Australia was probably illegal.
There are two types of futures trading; each can be applied to each of the instruments, like shares and bonds, which, bought directly for cash, monetise what used to be after-tax profits. The first type is, as it were, a second step removed from economic activity as such. This is futures trading per se: contracting to buy or sell at a future date, at a previously negotiated price. Here the presumption used to hold, that commodities, for example, would actually change hands for money, as the agreed-on contracts fell due.
The other kind of futures contract, called an option, moves another step further away from economic activity as such. Now what is bought or sold is the right, but not the obligation, to buy or sell a commodity, share, bond, or money, at a future price on an agreed-on date.
Where the futures contract speculates on what the price that would have to be paid against delivery will be, the option simply speculates on the price.
At yet another remove from economic activity per se is an index. An index is not the right to buy a commodity or share in the future which is traded, but the future movement of an index based on a basket of shares, commodities, bonds, or whatever. To re-emphasise, you are now far, far removed from the physical economy, and merely betting on whether the values of indexes (mere numbers in electronic hyperspace) or future prices in some piece of paper, will go up, or go down. There is no difference whatsoever in this, versus betting on either the red or the black in roulette. However, it is much worse than that, because derivatives suck money out of investments in the real economy into pure speculation. Due to the principle of leverage, they can return anywhere from a “modest” 15% per annum, to 2000% or more, so who would invest in real production, which might only return 5-6% per annum? Thus, we have US$400 trillion in debt worldwide, but farmers or industrial entrepreneurs frequently can not get a loan at all, or, if they do, they have to pay exorbitant interest rates, which effectively loots their business. One of the reasons why the concept of derivatives—which people would view as insane in a healthy, functioning physical economy—are viewed these days as “normal”, is because great masses of the population of Australia and other western countries have themselves become inveterate gamblers, either in gambling itself, or in that other form of gambling known as the share markets—a form of mass psychosis. Thus, as LaRouche has frequently charged, the population itself is directly complicit in the disasters befalling them, for which populists love to merely blame “the politicians.” It was for good reason that gambling used to be illegal. Look, for instance, at the devastating problems in Victoria, which relies on poker machine taxes for $1 billion a year of its state budget. As Rev. Tim Costello aptly summed up the situation recently, “At least half of this money comes from the pockets of problem gamblers. This represents lost marriages, a suicide every fortnight, theft, crime and social destruction which affects the rest of the community.”
Leverage
Look, for a moment, at this comparison of gambling and derivatives. First, imagine that you are gambling entirely with borrowed money. If you win, your winnings are “free money”, because you put up no money in the first place. However, if you lose, you may have to pay some steep consequences (depending on how much you borrowed), having to get a second job to pay off your gambling debt, selling your house, etc.
Borrowing money to gamble is a simple form of “leverage”, which is the essential principle behind derivatives. For a rising market, that seems to work well. Take the recent hyperinflating property markets in Sydney, Melbourne, Hobart or many other major cities. For years now, if you had borrowed most or all of the money you needed to buy property (or shares, for that matter), you could almost be assured of paying back your loan and making a profit, because, as a result of the speculative bubble, property prices were constantly rising. However, much like the Dutch tulip bulb craze of the 17th Century (see accompanying article), any speculative bubble has to pop, sooner or later.
The derivatives business is very similar, in that no one ever pays for the face value (notional principal amount, as it is called) of the derivatives contract, but only a small portion of it, the margin (like buying shares on margin). For instance, if I buy a $1 million derivative on margin for $10,000—1%—then sell it for $11,000, I make a $1,000 profit without ever having to come up with the $1 million. If the price goes down, and I sell it for $9,000, then I lose $1,000. This is the way the derivatives players figure their risks. And, if you are buying and selling huge numbers of contracts, as derivatives traders frequently do, this quickly turns into a lot of money.
This process works, after a fashion. As long as there is someone out there who wants to buy your derivatives for something near what you paid for them, you can survive. Should the price drop below what you can afford to cover, you go bankrupt, but the market itself survives. But what happens to this pyramid scheme when there are no buyers?
When there are no buyers, everyone who holds derivatives is suddenly liable for the face amount: Your $10,000 has bought you $1 million of debt, which you can’t pay. You’re broke, and therefore your creditors are broke, because you can’t cover your debts to them. What erupts, is a chain-reaction collapse. The leverage which allowed the bubble to expand so rapidly, changes to reverse leverage, and the system disintegrates, virtually overnight.
Look at a real life example, that of the infamous U.S.-based Long Term Capital Management (LTCM) hedge fund, whose collapse in 1998 has been widely admitted to have almost blown out the entire world monetary system, which was hanging by a thread for days. LTCM used $2.2 billion in equity put up by its original investors, to borrow some $125 billion. It then used that $125 billion to enter into derivatives contracts with a notional value (face value) of $1.25 trillion. LTCM was therefore able to leverage each dollar of equity into at least $57 in assets, and $568 in derivatives bets, winning enough to pay off its borrowings and book huge profits—until it collapsed.
Reverse leverage
Just as LTCM’s profits were multiplied through leverage while it was winning, its losses were multiplied through reverse leverage when it lost its bets: losses on its trillion-dollar derivatives portfolio wiped out its equity in a matter of weeks, leaving it unable to pay its debts, forcing its creditors to foreclose. The geniuses who ran LTCM had just the year before won the Nobel prize for economics, for coming up with a “sure-fire” formula for derivatives speculation. This process of reverse leverage is now dominating the global financial markets. The trillions of dollars of notional financial values which have disappeared, have triggered substantial losses throughout the system. The system itself, has switched from expansion and inflation, to contraction and deflation; from maximizing income, to minimizing loss. The commercial banks, facing heavy losses on their own derivatives trading and on loans to other speculators, are increasing their demands for collateral to hedge funds and other lenders. And the banks are in an extremely precarious situation themselves. The huge JP Morgan Chase in the U.S., for instance, has a derivatives exposure so great, that a loss of just 0.16% of its derivatives portfolio would wipe out its entire $43 billion in shareholder equity. When the banks demand more collateral of the hedge funds, they, in turn, have to sell assets to meet the demands of their lenders. Due to the collapse of world share and bond markets, many of these assets are being sold at a loss, worsening the financial problems of the sellers. Since selling into a declining market tends to drive the market down even further, the entire process turns into a vicious cycle, in which selling to cover losses creates more losses, which requires more selling, and so on.
LaRouche’s Triple Curve
The best way to understand this whole process is through the now-famous “Triple Curve” function, which LaRouche designed in 1995 to help people understand why, under the rules of speculation-driven globalisation, the world monetary system necessarily had to collapse. There are three intersecting curves: financial aggregates (shares, bonds, derivatives, etc.), monetary aggregates (money supply) and the actual physical economy. (These curves do not represent actual numbers, but trends.) As the speculative bubble in financial aggregates grows, in order to keep it from popping, the central banks have to pump in newly-created money to keep the system liquid (i.e. buying and selling these massive amounts of financial aggregates, such as derivatives, requires more actual money). This is what Alan Greenspan at the U.S. Federal Reserve board did throughout all 2001 (and is still doing), for instance, when he lowered the interest rate 11 times, in order to pump more money into circulation. This is the “wall of money” phenomenon, where the central banks throw a wall of money at the speculative bubble, in utter panic that it will blow out. At a certain point, the growth rate in the amount of money which must be pumped in to keep the system afloat, becomes larger than the rate of growth of the financial aggregates themselves (where the monetary aggregates crosses the financial aggregates curve), and Weimar Germany 1923-style hyperinflation sets in, where you had to take a wheelbarrow of money to the store to buy a loaf of bread. And all this time, the growing bubble sucks money out of the actual physical economy (the lowest curve) which is what actually sustains the paper in the first place, whether money or financial aggregates. It is like a five hundred pound flea on a dog: sooner or later, it will suck its host dry, and then where will it be? In 1993, LaRouche proposed a one-tenth of one percent (.1%) tax on all financial turnover—most of which go untaxed, unlike purchase and sales of goods. The biggest component of financial turnover was, and is, derivatives. His concern was both to help dry out the speculation by taxing it, as well as for authorities to begin to get a handle on exactly how big the problem is. The CEC picked up that demand for Australia, which would have brought in $36.975 billion for the $36.965 trillion in financial turnover in 1996, and in 2000-01, would have brought in $42.781 billion on $42.781 trillion in turnover. This could easily finance all the great water projects and mag-lev railroads specified in the CEC’s Feb. 2002 issue of the New Citizen. However, such a tax at this point is moot, because the system itself is now blowing up.
Australia’s skyrocketing derivatives market
Let’s take an example of an actual derivative, an interest rate swap. This one is very close to home, since it is the derivative through which the Treasury managed to lose a staggering $5-6 billion, as revealed in February of this year.
The June 2002 Reserve Bank of Australia Bulletin defines an interest rate swap as “an agreement between two parties to exchange interest rate obligations over a period of time. In its most common form—a fixed-to-floating rate swap—the parties agree to net off a fixed rate payment against a floating rate payment, with the difference being paid by one party to another...While swaps can be used for a number of purposes, one common use is to hedge exposure to interest rate movements. As an example, assume the two parties to the swap contract have differing views on the way interest rates will move. One party may have a floating rate liability and will be worried that interest rates will rise (making its obligation more expensive.) To protect against this eventuality, it can exchange its stream of floating rate payments with a fixed stream so as to ‘lock in’ existing interest rates. The other party would obviously adopt the reverse strategy. If interest rates rise, the party with the original floating rates obligation is compensated by the party with a fixed-rate obligation and vice versa if interest rates fall.”
In the case of the Treasury’s gambling, it agreed to swap obligations to pay interest in Australian dollars, for obligations to pay interest in U.S. dollars, a so-called cross-currency interest rate swap. Since the Australian dollar fell from around 80 U.S. cents when the deal was made, down into the 50’s, the Treasury lost, big-time.
Treasury learned from the experts. In 1987, they brought in the world-famous Barings Bank to show them how these exotic new things, derivatives, worked. A few years later, in 1995, Barings went bankrupt because of its speculation in derivatives, a bankruptcy falsely blamed on one 27-year old “rogue trader” in its Singapore office, the hapless ex-shoe salesman, Nick Leeson.
As noted earlier, no one has any real idea how bad the derivatives problem is, either in Australia, or globally, because no accounting standards anywhere (nationally, or in international institutions such as the IMF or the Swiss-based Bank for International Settlements) demand that such records be kept. However, we do know that the turnover in derivatives on the SFE financial futures exchange in Sydney hit $A10.25 trillion in 2000 on 31.2 million contracts—which was only part of the total, and did not include the big banks and the derivatives traded on the Australian Stock Exchange, among others. This is up from $A 2 trillion in 1993. And the rates of growth in derivatives are skyrocketing even faster than the real estate market. In 2000-01 over the previous year, swaps (which totaled $1.470 trillion) grew a staggering 69.4%; forward rate agreements grew 58.1%, OTC equity derivatives grew 37.3%, and credit derivatives by 53.3%, according to the Australian Financial Markets Association. Imagine, for a moment, a chart which has the categories of shares, commodities or cash noted at the top, and then, in descending order, futures, options, options indexes, futures options, futures options indexes, and swaps. Each of these gets more removed from any actual physical reality (even of pieces of paper) than the previous one. Add to that, that almost every day, new, even wilder forms of derivatives are cooked up, such as credit default swaps, total rate of return swaps, credit spread options and credit baskets. Now, do you see why the international monetary system is about to blow? Remember, all of this would have been impossible without financial deregulation. And, if you had fixed exchange rates among currencies, as in the old Bretton Woods system, there would be no point in speculating in the most characteristic kind of derivatives, the movement of currency rates vis a vis each other, the one in which the Australian Treasury lost all our money. (The Australian foreign exchange market is ranked 9th in the world by turnover, while the Australian dollar is the world’s 7th most actively traded currency.) Finally, just for the record, here are the derivatives exposure of the Big Four banks, as recorded in their annual reports, which dwarf each of the banks’ equity capital:
NAB: As at March 2002, notional principal value of contracts is $1.344 trillion. Westpac: $632 billion as of their 2001 report. CBA: $661.4 billion, according to their 2002 report. ANZ: As of March 2002, $549.67 billion for exchange rate and interest rate derivatives. Interestingly, the figure for 30 Sept. 2001 was much higher, at $805.077 billion. What happened to all those hundreds of billions? Without commenting on ANZ’s creditworthiness, when JP Morgan merged with Chase Manhattan, trillions of dollars in derivatives just plain disappeared—a sign that the merged bank was in deep financial trouble, and indeed, JP Morgan Chase has probably been secretly taken over by the U.S. Federal Reserve.
