Have you ever made a bet? Was that bet against the market? The medium for this type of betting is known as the derivative market – and it may lead to a global financial crisis.
But what exactly is the derivative market? What is a derivative? A derivative, according to Investopedia, is “a contract between two or more parties whose value is based on an agreed-upon underlying financial asset.” Basically, the value of the contract derives from the underlying asset. Common assets typically include commodities, interest rates, and bonds. You can think of it as a bet. For example, person A tells person B that the price of oil is going to rise starting at $100 per a barrel. To officially promote his claim, person A and person B sign a contract based on person A’s speculation. Now, if the price of oil rises above $100 per a barrel – say, $120 per a barrel – person A receives the difference between his speculated price and the current price (in this example, $120-$100 = $20). If he is wrong, person A loses that margin. The derivative market is simply the medium in which derivatives are traded.
A derivative can come in many forms, including futures, options, swaps, and warrants. For example, speculators may use a futures contract to make a profit on their conjecture of a commodity price increase. Farmers may also use commodity derivatives as insurance on their product. For example, a farmer may lock in an acceptable price of their produce, saying the price of their commodity is going to be lower. If the price does drop, the farmer still makes a profit on the difference between his set price and the current price.
To put derivatives in basic form, it is a bet on the market. Whether that bet is based on the price of a commodity or rising insurance rates is entirely based on the contract between the two parties.
Derivatives can be a feasible method to hedge your funds, just as in the case of the farmer. However, as with any form of gambling, there is a risk that can lead to a financial crisis.
With trillions of dollars of exposure to derivatives, several of the world’s largest banks have surpassed their amount of assets (see figure 2). The problem here is the fact that, if a bank loses out on their bet, they do not have enough assets to repay it.
A similar problem was encountered in 2008, with the crash of Lehman Brothers bank. According to Steve Denning, in an article contributed to Forbes magazine, “the root cause wasn’t just the reckless lending and the excessive risk taking. The problem at the core was a lack of transparency.” After the collapse of Lehman Brothers, no one knew the risks any particular bank took in their derivative exposures. In return, no economic activity was done between the banks. “Because all the big banks’ had been involved to an unknown degree in risky derivative trading, no one could tell whether any particular financial institution might suddenly implode,” says Denning.
However, after the collapse of Lehman Brothers, banks continued exposing themselves to derivatives – increasing the total exposure to $500 trillion globally. If the banks collapse due to derivatives, it could lead to a stagnant market.
In addition to this, a new bill (Bill 292-I22) – drafted entirely by Citigroup lobbyists – passed December of 2015. This bill repeals the Dodd-Frank Law, ensuring Congress bails out the banks – even if they lose out in the derivative market. However, with trillions of dollars in derivatives exposure, this could prove to be a difficult task.