Lets talk about Derivatives and the EuroZone Crisis

I have spent the last 32 years of my life working on and around ‘Wall Street’.  Specifically, for companies who primarily trade and clear what are known as financial derivatives.  I am not certain if this makes me an expert in anything but I do think I have some knowledge about how the derivative markets work.

First, what exactly is a derivative?  In it’s simplest form a derivative, at least in Wall Street financier language, is any product who’s value depends or ‘derives’ from the value of something else.  I spent a lot of time trading Gold and Silver Bullion so I will use them as an example.  The price of Gold fluctuates in the open market.   I can go down to the corner coin shop and purchase a Gold coin and I will pay the price of Gold and probably some markup so the guy can run his store.  The value of that coin is what the market says it is.  I go home put that coin under my mattress or in my bank vault and I can be secure in knowing the value it has will be related to the price of Gold in the fair market.  I can take that coin out and hold it in my hand anytime I want to.  Pretty isn’t it?  It is mine I paid for it and I am free to do what I will with it.

But there are other ways to invest in Gold.  I could call up my friendly broker and open up a futures account and buy something known as a futures contract whose value ‘derives’ (there’s that word again) from the price of Gold.  I could even hedge my coin by selling a futures contract, assuming they represented the same quantitiy of Gold.  Wait it gets better, I could tell my broker to purchase a put or call option on a futures contract and be exposed to the price movement of Gold.  So that option would be a derivative on a derivative.  I could buy an ETF that tracks Gold, I could sell short that ETF or I could buy or sell puts or calls on that ETF.  I could do a combination of all these things.  I could trade Gold in the Spot and Forward OTC markets.  I could trade options on those contracts as well.  And I am just scratching the surface here.  By now you probably are getting the point.  There are many ways to get exposure to the movement in the price of Gold, either up or down.  Depending on how leveraged I am the Gains or losses will be magnified.

This is how the derivatives markets work.  It is legalized gambling as only a tiny percentage of the folks who are placing these bets actually either produces the stuff (miners, refiners) or uses the stuff (jewelers, electronics makers etc.)   The rest of the folks are just speculating on the price movement.  While this creates a whole industry which employs thousands of people which is good, it also magnifies the price movements and leaves the price discovery mechanism at risk to manipulation.  And manipulation happens! That is the point.

What does all this have to do with the EuroZone Crisis?  I am getting there, bare with me.

I have benefitted from the markets in derivatives for all of my adult life and for the most part the people who do this for a living are decent, caring honest people who work hard, love their families and are by and large responsible citizens.  But greed does exist, and the bigger the prize the greater the incentive to do bad things.  Leverage in the wrong hands is like a nuclear bomb in the wrong hands.  Bad things can and do happen.

The same way a derivative market exists in Gold and Silver and Corn and Wheat and on and on, derivatives markets exist for fixed income investments.  Soverign debt is a type of fixed income investment.  All the US debt trades, all the debts of pretty much all the countries trade.  So what is the problem you may ask?

Well as I see it, when you allow the Debt of a Soverign country to trade in a derivative market, subject to manipulation due to excessive leverage you might find that certain traders have an interest in seeing the price move one way or another.  This may be all well and good for markets of Gold and Silver and Corn and Wheat (it probably is not but that is a different article) because those markets do not underpin economies and money supplies. And in most cases producers and consumers in those markets are free to realocate resources based on the price fluctuations of those commodities.

In the case of Soverign Debt the story is much much different.  The capital markets at the very core exist to do one thing and one thing only:  permit the free flow of capital from the folks who have excess capital (those that earn more then they spend) to the folks who are in need of capital (those that spend more then they earn).  In the case of Soverign Debt we are talking about countries who borrow money because they spend more then they earn (tax).  Allowing speculation in the market for Soverign debt is not like putting the fox in charge of the chicken coup, it is more like inviting the fox for dinner in the chicken coup! What do you think is going to happen?  Precisely what is happening.  The speculators are raiding the markets and while creating wealth for themselves, perhaps destroying the capital markets for many generations to come.

I could go on and on but where I am going is simple.  The answer to the Eurocrisis is not for the ECB to buy more soverign debt, the answer is to disallow the trading of derivatives on the soverign debt.  Let the markets do what they are good at, which is to efficiently allocate capital.  If the market sees fit to raise the rates on certain countries debt because it is viewed as more risky relavant to some other asset so be it.  But allowing the speculative interests to undermine the economic system is absolutely suicidal!.  The result could be a worse recession then the one we just came out of.

It is time for the Central Banks of the world to demarketize the soverign debt markets. NOW.

This entry was posted on November 18, 2011 at 10:48 AM and is filed under Derivatives. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response or trackback from your own site.

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