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Everything you need to know about the financial transaction that ate the world economy

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Monia Mazigh

Would you like a “future,” a “plain-vanilla mortgage,” a “European option,” perhaps a “swaption”? You might think these are the latest exotic offering at a your local hipster café, but they are in fact complex financial instruments. More precisely, they are all examples of the now infamous “derivatives.” Derivatives, so little known and even less understood by most of us, and so cherished by bankers and speculators, have been around since the 1970s, but the financial crisis which began in the U.S. three years ago, and is currently rocking Europe, has put them under an unaccustomed spotlight.

This article will try to demystify what is a complex and difficult subject. Throughout, I will try to explain what makes these products “tick,” as it were, and why this ticking should be making all of us very nervous.

But let’s begin at the beginning: what is a derivative? And why does it have this odd name? At its most basic level, a derivative is simply a contract between two people, or two financial institutions. It’s not a real asset, such as a car, or a piece of machinery, but rather a “financial instrument” designed to serve certain purposes. However, its value does depend on, or is derived from, the trading price of the real asset underlying the contract, hence the name “derivatives.” A barrel of oil, for example, is not a derivative, but rather a raw material whose price will fluctuate on the market as a function of supply and demand. This is clear enough. But let’s consider the following scenario, two people enter into a contract on the following terms: If in six months time, the price of a barrel of oil is more than $100, the first person will pay the second person $10; however, if the price falls below $30, the second person agrees to pay the first person the same amount. What would we call this arrangement? It is, in fact, a simple example of a derivative in that the value of the contract ($10 in this instance) is derived from the value of oil.

Now sceptics will scoff that this is nothing more than a simple bet of one person’s loss being another’s gain, and there is something to that. Yet the proponents of derivatives retort that this is hardly the whole story. For the contract also functions as a form of insurance. Let’s suppose that the first person sells oil, and the second person buys it to keep her factory running. The contract they’ve entered into could provide some insurance for both of them against large swings in the price of oil. If, for example, the price of oil spikes, the second person would receive $10 to help offset her purchases, and similarly if it fell dramatically, the first person would get $10 to help make up for oil’s low sale price. In fact, the arrangement we’ve just described is what's called in the jargon of derivatives an “option,” and there are options both for selling, and for buying. There are so-called European options which can only be exercised when the contract expires, and there are other “American” options which can be exercised at any moment. There are also options on the share price of a company, on market indexes, on currencies, and indeed on all manner of other assets.

Also falling under the heading of “derivatives” and a favourite of the financial world, are “futures.” This is an agreement which, the day it’s signed, locks in the price at which I’ll buy or sell an asset or good at a given time in the future. Thus, I can buy today on the Chicago Board of Trade (CBT) a contract on the “future” price of wheat, that is, the price I think wheat will be selling at in six months time. There are all kinds of actors in the “futures” markets, some buying contracts and others selling. Some use these markets to protect themselves against risk, as we saw in the oil example above; businesses relying on primary resources will try to insure themselves against large price fluctuations.

But where matters become far more complicated, and dangerous, is with those players who are simply looking to make profits through speculating on future prices. This is not generally a game played by individuals, but rather large investment banks or hedge funds. As a result of their deep pockets, their generally highly-skilled traders, and their potent political connections, these investors can run roughshod over markets, operating with near-impunity, and even when they are caught with a hand in the cookie jar, or are suspected of fraud, as is the case currently with Goldman Sachs, the damage has generally already been done. It’s not for nothing that Warren Buffett, one of the world’s most famous investors, described derivatives as “financial weapons of mass destruction.” They can decimate entire companies, and even economies, as the case of Greece currently shows us.

Indeed, the nefarious uses of derivatives don't stop at speculation. Derivatives can also be called upon to cook the books, a practice politely euphemized as "risk management". In July 2003, an article appearing in the magazine “Risk,” shed light on how Greece, with the well-remunerated complicity of Goldman Sachs, had “engineered” currency swaps in order to decrease its debt ratio and skirt the allegedly rigorous membership requirements of the European Union. There are two important criteria for ensuring access to the Euro zone: the first is a ratio of debt to GDP of less than 60%, and a ratio of budget deficit to GDP of less than 3%. Greece’s debt ratio, however, stood at more than 100%, making its interest payments the highest in the Euro zone. Yet Greece, with Goldman's help, was able to use derivatives – in this instance, a currency swap – in order to temporarily mask its shortcomings, at least on paper.

There are different varieties of swaps, but in the case that interests us here, the currency swap is an agreement between two parties to trade the interest rates on their medium- and long-term debts calculated in two different currencies. According to the 2003 “Risk” article, it appears the contract between Goldman and Greece involved $10 billion over a period of between 15 and 20 years. The trade consisted of “swapping” Greece’s immense debts contracted in U.S. dollars or yen, in favour of new debts in euros. The trick was in finding an exchange rate which made it appear as if the debt in dollars/yen was far lower than it was, at least until the terms of the “swap” expired, at which point Greece would have to make a large balloon payment to Goldman. The idea was to put off repaying a debt in the hopes that, by the time it came due, Greece would have the money to pay it off. Certainly, this bit of Wall Street wizardry allowed Greece to deceptively lower its debt ratio, yet as a result the country today finds itself even more in debt, and insolvent, helping spur a recent massive, EU-led bailout.

The verdict of specialists and financial analysts on derivatives is mixed. Some see them as useful tools for conducting business. Greece's recent calamities are not the fault of derivatives, runs this argument, but rather of politicians who wanted to hide the truth of their country's situation from European regulators. Others simply lay the blame on Goldman and its obsessive pursuit of profit.

In my opinion, however, it comes down to a question of ethics. There simply cannot be a viable financial system in the absence of ethics. Certainly I understand that, up to a certain point, the pursuit of profits is to be encouraged, but this can’t become an end in itself. Derivatives are an excellent means to insure oneself against risk, but they have also become a “legal” way to escape taxes, a “legal” way to engage in fraud, and a “legal” way to mask the financial health of a business or entire country. Up until now, no country has had the courage to regulate the use of derivatives. The profit motives of the big investment banks have carried the day. Yet how many more bankruptcies, how many more financial crises, and how many more taxpayer-paid bailouts must we witness before we decide to impose some order on the financial world? A financial transaction tax, popularly called "the robin hood tax" would be a good place to start.

Dr. Monia Mazigh has a Ph.D. in Finance from McGill University. Her thesis was about the term structure of interest rates. She contributed to several research papers on derivatives.

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