Derivatives – a Beginner’s Guide to “Financial Weapons of Mass Destruction”

Over the last 4-5 years the term derivatives has been firmly embedded in todays lexicon. With the failure of Bear Stearns in 2008, and subsequent bailout of multiple other too big too fail banks, the term “derivative” was popping up everywhere.  Then recently we have JP Morgan’s $7 billion trading loss on credit derivatives in the news.  But have you ever stopped to think what exactly derivatives are, how do they work, and what risks do they bring?  Today we’ll try to unearth why Warren Buffet termed them “financial weapons of mass destruction” and cover…

• What is a derivative
• How they came about
• How they have changed over time
• What are the main derivatives in existence today
• What do these derivatives mean for New Zealand
• New Zealand’s own “hidden” derivatives

What is a Derivative?

First up a definition may be a good place to start.  From the lazy reseachers’s dictionary wikipedia:

Derivative: A derivative instrument is a contract between two parties that specifies conditions (especially the dates, resulting values of the underlying variables, and notional amounts) under which payments are to be made between the parties;

So they are financial instruments whose values depend on the value of other underlying financial instruments or objects such as commodities, equities (shares), residential or commercial mortgages, bonds, interest rates, or exchange rates.  They can take the form of futures, forwards, options and swaps.

The history of derivatives dates back to the 1800’s where they were used to hedge farmed commodities, given these are affected by so many variables and have an unknown eventual sale price.  So instead of Farmer Joe doing his planting, growing and harvesting and hoping he’d have a crop of a certain size that he could sell for a certain price to make a profit, he was able to – for a comparatively small fee – guarantee a fixed income at a specified date in the “future” for his crop.  So began the Futures markets.

Giving some level of predictability to farming income was very beneficial and enabled growth and advancement in many other sectors which eventually led to the industrial revolution.

So derivatives have their place as they have had many positive impacts on humanity since their invention.

Derivatives Morph: From Farmers Friend to Financial Weapons of Mass Destruction

However in the 2 centuries that have passed since then, derivatives have morphed into more of a financial casino where a few major players (5 main banks in fact whose names will not surprise you J.P. Morgan, Bank of America, Citi, Goldman and Morgan Stanley) actually control  96% of the industries derivatives as at 30 June 2011.   The chart below shows how small a percentage of derivatives are held by actual end users (green line) looking to hedge themselves, versus merely traded by the likes of the above 5 banks (blue line).

(For a graphical representation of the freakish size of these banks derivative books see this great infographic: http://demonocracy.info/infographics/usa/derivatives/bank_exposure.html)

Source

Rob Kirby gives a detailed overview of the full history of derivatives if you want all the holes filled in here.

Interest Rate Swaps are the Dominant Derivative

Apart from the massive change in traders versus end users that can be seen in the chart, the other major change in the past 20 or so years was the advent of the “Interest rate swap”.

Interestingly despite all the talk of credit derivatives (i.e. derivatives of loans/mortgages) being the cause of the 2008 financial crisis, it is actually interest rate swaps having a notional value of $504 Trillion that make up 78% of the total derivative pool of $647 Trillion (as reported by the Bank of International Settlements (BIS)  http://www.bis.org/statistics/otcder/dt1920a.pdf). Look again at the chart above and you can see the small amount that credit derivatives make up.  The yellow line represents credit derivatives versus the total notional derivatives in red.

Why Do Interest Rate Derivatives Now Make Up So Much of the Total?

Because as Rob Kirby states, it is these interest rate swaps which allow the US Fed/Treasury to control or manipulate the ”price of money”, that is the long term US treasury interest rate.

In times gone by Bond Vigilantes (no they didn’t take the politicianss into the street and hang them by their necks!) would sell government bonds and therefore drive interest rates up when governments were overspending.  Effectively the vigilantes would be saying to governments, “We don’t trust your ability to repay so we are selling your bonds and therefore you have to pay a higher rate to attract another buyer of your debt.”  This no longer occurs as demonstrated by Bill Gross’s PIMCO Bond Fund selling out of its massive stake of US treasuries in March 2011.  The treasury interest rate then promptly plummeted, just the opposite of what you’d expect.

To be honest the process through which the US Exchange Stabilisation (Fund ESF) manipulates the treasury interest rates is pretty complicated.  I’m not sure we can summarise and make it any simpler than Rob Kirby’s article (which we have gained much insight from), so below is an extract from that: (Otherwise just stick with “they create the demand out of thin air” and you won’t be too far from wrong!):

“++The ESF participates in these trades taking “NAKED INTEREST RATE RISK” – meaning they do not provide their counterparties with the requisite amount of bonds to hedge their trades – thus forcing them into the “free market” to purchase them. This generates UNBELIEVABLE “stealth” settlement demand for U.S. Government securities. This is how/why U.S. Government bonds and hence the Dollar can be made to appear “bid-unlimited” – even when economic fundamentals are SCREAMING otherwise. The amount of demand for cash government bonds that can be conjured out-of-thin-air in the derivative interest rate swap complex, which might be best described as “high-frequency-trade” on steroids – measured in hundreds of Trillions in notional – literally OVERWHELMS the cash bond settlement process. This means bond yields are set arbitrarily – in accordance with Fed / Treasury policy – NOT IN FREE MARKETS. This also explains why there are no identifiable end-users for the dizzying growth in interest rate derivatives [swaps] – the trade is all attributable to the Treasury’s ‘invisible’ ESF – an institution that is not publicly accountable to ANYONE or ANYTHING. This is why other nations can and do have, from time to time, failed bond auctions while America never has and NEVER WILL BE ALLOWED TO. This is all done in stealth to facilitate and give an air of legitimacy to the U.S. Treasury’s ZIRP [zero interest rate policy].”

So this is how they keep interest rates fixed close to zero in the US.  Of course this isn’t the case across the Atlantic in Europe where interest rates on government bonds of the likes of Greece and Spain have been reaching nosebleed levels of late.

Euro Denominated Interest Rate Derivatives could be the Source of Big Trouble

Going back to the BIS data we can see that $184 trillion of interest rate derivatives are in Euros while only $161 trillion are in US dollars (as of Dec 2011).  So factor in that most banks borrow short but have large loan books at fixed rates for long periods. Therefore a big rise in interest rates could trigger claims on these interest rate derivatives.  (Hat tip to Alf Field for this point).