Well, now we know that he was right. It does not make things any better though.
But why are derivatives WOMD? For me, in spite of all the positives mentioned by the financial industry and economists, it is because they remove the original link and logic to the underlying instrument and create counter-objectives for users of the derivatives?
First, a definition, courtesy of Wikipedia (as usual these days):
Derivatives are financial contracts, or financial instruments, whose values are derived from the value of something else (known as the underlying). The underlying on which a derivative is based can be an asset (e.g.,commodities, equities (stocks), residential mortgages, commercial real estate, loans, bonds), an index (e.g.,interest rates, exchange rates, stock market indices, consumer price index (CPI) — see inflation derivatives), or other items (e.g., weather conditions, or other derivatives). Credit derivatives are based on loans, bonds or other forms of credit.
Because the value of a derivative is contingent on the value of the underlying, the notional value of derivatives is recorded off the balance sheet of an institution, although the market value of derivatives is recorded on the balance sheet.
What the derivatives do is create an instrument that is related to the underlying instrument, but not necessarily in the same way that the original instrument intended it to be.
Take stocks, for example. The shareholding structure of a public company is meant to align the goals of the shareholder with those of the company. A shareholder wants his or her share to go up. A short seller, in contrast, a holder of a derivative instrument, wants the share to go down. This is counter to the purpose of the original share instrument.
Take loans. A bank providing a mortgage loan to an individual wants the loan to be paid back on time. However a bank who then securitizes the loan immediately passes all or part of it to another party. The other party now should bear the need to have the loan paid back, and the originator has now practically walked away from their responsibility for the loan.
It is this breakdown in purpose – derivative disconnect – that is the real reason why derivatives are natural weapons of destruction.
Now, they are not necessarily weapons of mass destruction, at least not in their raw state. What happens to make them lethal at mass scale, in my view, is the following:
- People in the financial industry make money when money ‘turns’ – taking a percentage or portion of each transaction
- This percentage benefits the banks, institutions and individual workers directly as they receive bonuses based on transactions, and the more the volume, the more the personal and corporate benefit
- The first users of derivative instruments could benefit tremendously as it would give them a first mover advantage in terms of extension of capital it could ‘create’
- But rapidly other institutions and individuals would follow…
- And the number, type and scope of derivatives would multiply massively…
- Creating layer upon layer of derivative instrument…
- All interconnected… either directly as the credit card loan spawned syndicated loans, sliced up slice after slice…
- or indirectly as the same institutions took on a merry-go-round of different types of derivative…
- And at each turn of the merry-go-round, the amount of ‘money’ created through these derivatives became larger, and larger…
- … much larger than the value of the ‘real assets’ or transactions upon which they were, once upon a time, based
The amount of derivative assets in the system is mind-bogglingly massive (I spotted a post at NB Charts on quantifying the size of derivatives in the system).
So, to wrap up as I have real-world work to do, my argument is simple:
Derivative instruments disconnect the derivative from the purpose of the underlying instrument. In doing so, given the way that people follow and people try to get more money, the derivative instruments multiply and expand massively, so that they no longer bear any relationship at all to the underlying instrument. They become, in effect, a vast non-regulated Ponzi scheme. And the size of the industry that has been created, within a few short years, is nothing short of a lethal Weapon of Mass Destruction.
Go to California, Vegas or Florida and look at the empty homes if you do not believe me – or the UK. Go to Detroit and ask the car workers. Just don’t go to the Hamptons where the recently unemployed bankers get to put their feet up, relax, enjoying their pyramid-scheme bonuses from the last few years whilst they do not have to fight the morning commute into Wall Street.