Tuesday 22 December 2015

“Derivatives”:  When Wall Street Went Postmodern!

Ever since Michael Moore’s 2009 film,  Capitalism, a Love Story, in which Moore stood outside office buildings on Wall Street asking “Can you explain to me what a derivative is?”  the question has stuck in the back of my mind.  What is a derivative?

The fall of the Berlin Wall in 1989 was the end of Communism; 2008 with the biggest financial institutions in the world on the verge of collapse was the end of Capitalism.  In 2008, the world’s leading capitalists—bankers, executives, CEOs, stock-market gurus—became nouveau socialists accepting hundreds of billions of dollars in government bailouts.  (Welfare is so much easier to accept when it isn’t being wasted on poor people like homeless vets and single mothers in need of daycare.) 

But what caused the immanent financial collapse?  Subprime mortgages (poor people again, screwing up the system buying houses they can’t afford) and “derivatives.”  That question again, sounding like a bad joke:  what’s a derivative?  Since they just about caused the apocalypse in 2008, you’d think that by now we would all know exactly what they are.

I had heard that Wall Street financial companies had hired small armies of science geeks and they in turn created derivatives which were super complicated mathematical formulas, logarithms, which no-one understood (other than, I assume, the wizards who created them), but were sold all over the place and created enormous profits for the lucky few who could afford to buy them.  From these tidbits of information I imagined derivatives to be something like a chemical formula which could reduce the effects of ageing, or maybe a computer code which produced the coolest video game ever.

However, reading Tony Crilly’s Mathematics (love this book; it’s sort of a history of mathematics for dummies like me), I discovered that “derivatives” are part of that form of mathematics called “the Calculus.”  The Calculus was developed simultaneously and independently of one another by Gottfried Leibniz and Isaac Newton.  Newton used his newly invented mathematics to explain (quite accurately as we now know) the planets oblong orbit around the sun.  (Crilly is insistent  that it’s always referred to as “the Calculus.”  I actually studied “the Calculus” in high school.  The only thing I remember about it is that we called it “calculus.”)

“Derivatives,” as Crilly explains, are part of that branch of the Calculus called “Differential Calculus.”
“The central purpose of Differential Calculus is to measure the rate of change—how fast or slow change occurs, and this is known as the ‘derivative’” (Crilly 77).  
Crilly eventually gives the example of Black and Scholes who used Differential Calculus “to try to predict stock prices” (Crilly 84).

In short, “derivatives” are mathematical calculations which attempt to predict how prices are going to move on the stock market.  So now we know—or do we?  Even with a scientific definition in hand, I found it hard to imagine that this is what the financial leaders on Wall Street were doing—trading tips with each other like old-fashion bookies and gamblers.  “Hey Bud, I got a hot tip for the seventh race at the Belmont this afternoon!”  Were these guys really paying each other millions and even billions of dollars for the equivalent of a tip that Son of Samantha was going to win the seventh race at Belmont this afternoon based on a calculation using Differential Calculus?

Then I found out what “derivatives” really are.  This week in fact.  What I should have realized is that Wall Street  shysters were doing exactly the same thing as postmodern academics, using a scientific term which connotes something complex, highly technical, and esoteric but which also has an ordinary, accessible meaning in common language.  The gambit is to endlessly obfuscate, never letting slip in what sense the word is being used, creating the illusion that what is being done is far beyond the comprehension of the average human brain and impossible, therefore unnecessary, to explain in straightforward, accessible, transparent language. (For further discussion of this phenomenon see The Postmodern Hoax and How We Train University Students to Write Poorly.)

A derivative is simply something that comes from something else:  orange juice is derived from oranges, maple syrup is derived from the sap of the maple tree, saying “bless you” when someone sneezes is derived from the medieval belief that the devil can enter your body when your orifices are open, and the word “derive” derives from the Latin derivus (meaning down stream). Ironically “derivative” as the term is used in financial markets carries some of the same meaning as it does in literary studies.  Describing a literary or artistic work as “derivative” is generally an insult, meaning that it is an imitation of someone else's style lacking the substance, aura and originality of the source. 

In the financial markets derivatives come in many forms and they have names like “options,” “swaps,” “futures,” “forwards,” warrants,” “LEAPS,”  “baskets” and “swaptions.”  What all these “financial instruments” (as they are called) have in common is that the profit or loss they produce is “derived” from the stock market.  Or, in the literary sense of the term, if your derivative imitates what happens on the stock market you make money, if it doesn’t you lose.  The horse race analogy turns out to be pretty apt.  If your choice of Son of Samantha in the seventh “imitates” what actually happens in the race you will “derive” a profit from the result.  When you purchase a derivative, you are not actually buying a stock or investing in a company, you are not buying or investing in anything, just as when you bet on a horse race you are not buying a horse or a piece of a horse or anything else.  Ultimately the derivative is the equivalent of putting you money on red at the roulette table.  Your profit or lose will be derived from whether or not your choice imitates what the little ball spinning around the roulette wheel does.

Are you still there?  Perfectly justifiable that you started to get a bit bored about two paragraphs back.  You’ve already gotten the idea:  Wall Street billionaires and their middle-management millionaires aren’t investing, or building or growing anything; they are just betting on what’s going to happen on the stock market, the same way you and I might bet on a horse race or football game or buy a lottery ticket.  So what.  Before apathy sets in, consider this:  they are doing it with your money!

If you have a bank account, a pension fund , a loan payment of any kind, your money is invested in derivatives. If you are affected by currency rates, interest rates, the price of food or gas or clothing; then you are affected by the derivatives market.  The problem isn’t that financial institutions are gambling.  In fact, it’s not really gambling for them, because they are using your money. Yes, they are betting your money on Son of Samantha at the track and Number 23 on the roulette wheel, but the financiers on Wall Street and global investment bankers are not that worried about the outcomes . . . because it’s your money and they get paid for betting it no matter what the outcomes.  In addition to any profit they might make themselves, they can charge fees, commissions, and administrative expenses, skimming from any pot of money they touch while accepting salaries, bonuses, and tax exemptions, deferrals and rebates.  In short, yes they are gambling, but they also own the race track and the casino.  

However, unlike race tracks and casinos, the derivatives market is unregulated.  It has been seven years since derivatives nearly collapsed global financial markets.  People lost houses and jobs and pensions, but no-one has ever been charged with a crime.  You can’t be accused of breaking the law when there are no laws.  

How much money are we talking about?  This is when we move beyond any notion of reality and into the realm of fantasy and the fantastic.  No-one knows exactly how much money there is in derivatives right now because . . .  (wait for it)  . . . . derivative markets are unregulated.  The current estimates run between 710 trillion and 1.2 quadrillion US dollars.  

How much is 1.2 quadrillion USD?  Think "a lot" then add some more zeros.  To get a handle on how much money we are talking about, let’s use the conservative estimate of 710 trillion.  Now consider:  the GDP (Gross Domestic Product, the value of all goods and services in one year) of the USA last year was 17 trillion dollars.  In other words the derivatives market is estimated to be more than 40 times larger than the US economy.   The total US debt is around 18 trillion dollars.  The total amount of US currency in circulation 1.39 trillion.  

Does anyone else find it funny that the US owes about 15 times as much of its own currency as actually exists?  Or that there are 700 times more American dollars in the derivatives market than actually exist in the world.  This returns us to the question of “what is money” discussed in “When Should You Repay Your Student Loan?”  Liquidity has become so rapid and massive that printed money can’t keep up.  Postmodern money is at least twice removed from reality—beyond paper and material value.  Detached from reality, economy has become little more than the big boys moving big numbers about, but in this context what does “we can’t afford it” mean?

Jessica Mauboy heard it through the grapevine.

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