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The Derivatives Markets

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Money, Markets, and Democracy

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Abstract

The reason why derivative markets have grown so stupendously is democracy. By its natural evolution toward a fiat currency, democracy has increased market volatility, forcing individuals and firms to seek protection in a whole new array of derivative instruments. Among those are gold futures, which I put forward here as a measure of the depreciation of the US dollar since the move to fiat money. Oil’s price gyrations are explained as a product of that move as well. I isolate the options embedded in Collateralized Debt Obligations (CDOs) to show that the US sub-prime mortgage crisis resulted from a knowledge problem faced by investors. And I discuss the role of credit default swaps in that crisis, while pointing to the dangers of new derivatives regulations.

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Notes

  1. 1.

    Warren Buffet, “2002 Chairman’s Letter” in Berkshire Hathaway 2002 Annual Report, 15, http://www.berkshirehathaway.com/2003ar/2003ar.pdf

  2. 2.

    Google Ngram Viewer, http://books.google.com/ngrams/graph?content=derivative+security&year_start=1950&year_end=2000&corpus=15&smoothing=3&share=

  3. 3.

    OTC data from Bank of International Settlements, “Semiannual Derivatives Statistics” (November 5, 2015), http://www.bis.org/statistics/d5_1.pdf; Exchange-traded data from Bank for International Settlements, “Exchange Traded Derivatives Statistics” (September 13, 2015), http://www.bis.org/statistics/d1.pdf. It should be noted that the BIS data on exchanged-traded derivatives is limited to financial derivatives and does not include commodity futures and options. Hence, the $58 trillion that BIS reported for year-end 2014 understates the totals for exchange-traded derivatives.

  4. 4.

    ISDA, “ISDA Market Survey Data”, http://www.isda.org/statistics/pdf/ISDA-Market-Survey-historical-data.pdf

  5. 5.

    Quote from Luke Zubrod, “Four Years Later: Dodd-Frank and Derivatives”, Unconventional Wisdom (August 1, 2014), at http://www.institutionalinvestor.com/blogarticle/3367200/four-years-later-dodd-frank-and-derivatives/asset-management-regulation.html#.VkS7FnarTcs

  6. 6.

    John Hall, Options, Futures, and other Derivatives, (Upper Saddle River, NJ: 2009), 118.

  7. 7.

    Ernst Juerg Weber, “A Short History of Derivative Security Markets”. In Vinzenz Bronzin’s Option Pricing Models: Exposition and Appraisal, eds. Wolfgang Hafner and Heinz Zimmerman (Berlin: Springer, 2009), 434.

  8. 8.

    Ernst Juerg Weber, “A Short History of Derivative Security Markets”. In Vinzenz Bronzin’s Option Pricing Models: Exposition and Appraisal (Springer, 2009), 436–437.

  9. 9.

    Edward J. Swan, Building the Global Market: A 4000 Year History of Derivatives (London: Kluwer, 2000), 113–126.

  10. 10.

    Charles Mackay, Extraordinary Popular Delusions and the Madness of Crowds, 95–96; For a discussion of futures and forward trading beyond tulips that took place in Amsterdam, see Oscar Gelderblom and Joost Jenker, “Amsterdam as the Cradle of Modern Futures and Options Trading, 1550–1650”, in The Origins of Value: The Financial Innovations That Created Modern Capital Markets, eds. William N. Goetzmann and K. Geert Rouwenhorst, 189–206, (Oxford: Oxford University Press, 2005).

  11. 11.

    Donald Spence, Introduction to Futures and Options, (Cambridge, UK: Woodhead Publishing, 1997), 24–26.

  12. 12.

    Franklin Allen and Douglas Gale, Financial Innovation and Risk Sharing (Cambridge: MIT Press, 1994), 27.

  13. 13.

    Charles Mackay, Extraordinary Popular Delusions and the Madness of Crowds, 96.

  14. 14.

    Lynn Stout, “Derivatives and the Legal Origin of the 2008 Credit Crisis”. Harvard Business Law Review 1 (2011), 12.

  15. 15.

    Reuven Brenner and Gabrielle A. Brenner, Speculation and Gambling: A Theory, a History, and a Future of some Human Decisions (Cambridge: Cambridge University Press, 1990), 92.

  16. 16.

    Financial Crisis Inquiry Commission, The Financial Crisis Inquiry Commission Report; Lynn Stout, “Derivatives and the Legal Origin of the 2008 Credit Crisis”, 19–20.

  17. 17.

    Jim Cosgrave and Thomas R. Klassen, “Gambling against the State: The State and the Legitimation of Gambling”, Current Sociology 49, No. 5 (2001), 3.

  18. 18.

    Kristen L. Willard, Timothy W. Guinnane, and Harvey S. Rosen. “Turning Points in the Civil War: Views from the Greenback Market”. American Economic Review 86, no. 4 (1996): 1001–18. I have relied on this article for the discussion immediately below.

  19. 19.

    Yale School of Management: International Centre for Finance, “Greenbacks: 1862–1878”, http://icf.som.yale.edu/sites/default/files/financial_data/greenbacks.xls

  20. 20.

    Marc D. Weidenmier, “Turning points in the US Civil War: Views from the Grayback market”. Southern Economic Journal (2002): 875–890.

  21. 21.

    Jerry W. Markham, A Financial History of the United States: From the Age of Derivatives into the New Millennium, Vol. 3 (Armonk, NY: M.E. Sharpe, 2002), 43.

  22. 22.

    Thomas Conlon, Brian M. Lucey, and Gazi Salah Uddin, “Is Gold a Hedge Against Inflation? A Wavelet Time-Frequency Perspective”, SSRN Working Paper, (October 6, 2015), http://ssrn.com/abstract=2670896; Dirk G. Baur and Brian M. Lucey. “Is gold a hedge or a safe haven? An analysis of stocks, bonds and gold”. Financial Review 45, no. 2 (2010), 217–229; Natalie Dempster and Juan Carlos Artigas. “Gold: Inflation hedge and long-term strategic asset”. The Journal of Wealth Management 13, no. 2 (2010), 69–75; David Hillier, Paul Draper, and Robert Faff. “Do precious metals shine? An investment perspective”. Financial Analysts Journal (2006), 98–106.

  23. 23.

    Central Intelligence Agency, The World Factbook (January 2015), https://www.cia.gov/library/publications/the-world-factbook/rankorder/2244rank.html

  24. 24.

    Jeffrey D. Sachs and Andrew M. Warner. “The curse of natural resources”. European Economic Review 45, no. 4 (2001), 827–838.

  25. 25.

    Michael Ross, “Will Oil Drown the Arab Spring”, Foreign Affairs 90, no. 5 (2011), 2–7. For an argument that the ability to buy support with oil money contributes more to regime stability than the ability to finance an army that can quell opposition, see Benjamin Smith, “Oil wealth and regime survival in the developing world, 1960–1999”. American Journal of Political Science 48, no. 2 (2004), 232–246.

  26. 26.

    Halvor Mehlum, Karl Moene, and Ragnar Torvik. “Institutions and the Resource Curse” The Economic Journal 116, no. 508 (2006), 1–20; James A. Robinson, Ragnar Torvik, and Thierry Verdier. “Political foundations of the resource curse”. Journal of Development Economics 79, no. 2 (2006), 447–468.

  27. 27.

    Kevin K. Tsui, “More oil, less democracy: Evidence from worldwide crude oil discoveries”, The Economic Journal 121, no. 551 (2011): 89–115.

  28. 28.

    Silje Aslaksen, “Oil and democracy: More than a cross-country correlation?” Journal of Peace Research 47, no. 4 (2010): 421–431.

  29. 29.

    OPEC, “OPEC Share of World Crude Oil Reserves 2014”, http://www.opec.org/opec_web/en/data_graphs/330.htm

  30. 30.

    Wilfrid L. Kohl, “OPEC behavior, 1998–2001” The Quarterly Review of Economics and Finance 42, no. 2 (2002), 209–233.

  31. 31.

    Rebeca Jiménez-Rodríguez and Marcelo Sanchez. “Oil price shocks and real GDP growth: empirical evidence for some OECD countries”. Applied Economics 37, no. 2 (2005), 201–228; World Bank, “Global Economic Prospects” (June 2012), http://siteresources.worldbank.org/INTGLBPROSPECTSAPRIL/Resources/box_6.html?iframe=true&width=580&height=550

  32. 32.

    Shahien Nasiripour, “US court scraps CFTC position limits rule”, Financial Times (September 29, 2012), http://www.ft.com/intl/cms/s/0/be191d8e-09a8-11e2-a424-00144feabdc0.html#axzz2F380q5gX; CFTC, “Statement of Support by Chairman Gary Gensler: Aggregation Provisions for Limits on Speculative Positions”, November 5, 2013, http://www.cftc.gov/PressRoom/SpeechesTestimony/genslerstatement110513c

  33. 33.

    Marco J. Lombardi and Ine Van Robays. “Do financial investors destabilize the oil price?” ECB Working Paper, no. 1346 (2011); Luciana Juvenal and Ivan Petrella. “Speculation in the oil market”. Federal Reserve Bank of St. Louis Working Papers (2011).

  34. 34.

    Michael W. Masters and Adam K. White, The Accidental Hunt Brothers, Act 2, (September 10, 2008), http://www.fpma.org/upload_library/200808HuntBrothersPartII.pdf

  35. 35.

    CFTC, “Interim Report on Crude Oil”, (July 2008), http://www.cftc.gov/ucm/groups/public/@newsroom/documents/file/itfinterimreportoncrudeoil0708.pdf; Lutz Kilian and Bruce Hicks. “Did unexpectedly strong economic growth cause the oil price shock of 2003–2008?” Journal of Forecasting, forthcoming.

  36. 36.

    Scott H. Irwin, Dwight R. Sanders, and Robert P. Merrin. “Devil or angel? The role of speculation in the recent commodity price boom (and bust)”. Journal of Agricultural and Applied Economics 41, no. 2 (2009), 383–384.

  37. 37.

    James D. Hamilton, “Understanding Crude Oil Prices”, University of California Energy Institute Working Paper (June 2008), http://www.academia.edu/157011/Understanding_Crude_Oil_Prices

  38. 38.

    James D. Hamilton, “Understanding Crude Oil Prices”, 2.

  39. 39.

    Murray Rothbard, Man, Economy, and State with Power and Market, 2nd ed. (Auburn, AL: Ludwig von Mises Institute, 2009), 846.

  40. 40.

    David Hammes and Douglas Wills, “Black Gold: The End of Bretton Woods and the Oil-Price Shocks of the 1970’s”, The Independent Review 9, no. 4 (2005), 506–507.

  41. 41.

    Barry Eichengreen, Exorbitant Privilege: The Rise and Fall of the Dollar and the Future of the International Monetary System (Oxford University Press, 2011), 65–66.

  42. 42.

    For statistical evidence that oil price jumps in the 1970s followed upon increases in the money supply, and hence devaluations in the US dollar, see Max Gillman and Anton Nakov. “A Monetary Explanation of Oil and Gold Prices During Postwar Stagflation and Recovery: 1957–1999”, Central European University Working Paper, no. 5/2000, (2000), http://papers.ssrn.com/sol3/papers.cfm?abstract_id=253318

  43. 43.

    The article that originally laid out the model is: Fischer Black and Myron Scholes. “The pricing of options and corporate liabilities”. The Journal of Political Economy (1973): 637–654.

  44. 44.

    Aristotle, The Politics, trans. T.A. Sinclair, (London: Penguin, 1992), 90.

  45. 45.

    Joseph de la Vega, Confusion of Confusions, trans. Sen McGlinn and Mike Gould (Arnhem, Netherlands: Sonsbeek Publishers, 2006).

  46. 46.

    Joseph P. Kairys and Nicholas Valerio. “The market for equity options in the 1870s”. The Journal of Finance 52, no. 4 (2012), 1707–1710; Geoffrey Poitras, “From the Renaissance Exchanges to Cyberspace: A History of Stock Market Globalization” in Handbook of Research on Global Stock Markets. ed. Geoffrey Poitras (Cheltenham, UK: Elgar, 2012), 105.

  47. 47.

    BIS, “Semiannual Derivatives Statistics” (November 5, 2015), http://www.bis.org/statistics/derstats.htm. Also, see BIS, “Exchange Traded Derivative Statistics” (September 13, 2015), http://www.bis.org/statistics/d1.pdf. It ought to be noted that the BIS numbers undercount the notional value of exchange-traded options as it does not include data on stock and commodity options. Unfortunately, the World Federation of Exchanges (WFE) does not provide a complete set of notional value data on exchange-traded options.

  48. 48.

    Laurent L. Jacque, Global Derivative Debacles: From Theory to Malpractice (Singapore: World Scientific, 2010), 161–168.

  49. 49.

    Laurent L. Jacque, Global Derivative Debacles, 115–121.

  50. 50.

    In writing the call, to whom does the senior tranche sell that option? The answer is the next mezzanine tranche. These in turn sell calls with a higher strike price to the equity tranche. In the end, the equity tranche holders are left with the riskiest situation, a simple long call position at the highest possible strike price, $105 in my illustration.

  51. 51.

    Peter J. Wallison, Hidden in Plain Sight: What Really Caused the World’s Worst Financial Crisis and Why It Could Happen Again (New York: Encounter Book, 2015), Chap. 10.

  52. 52.

    Niccolo Machiavelli, The Prince, trans. Harvey C. Mansfield, Jr. (Chicago: University of Chicago Press, 1985), Chap. 25.

  53. 53.

    Tocqueville, Alexis de Democracy in America pp.459–465.

  54. 54.

    David Hume, A Treatise of Human Nature, ed. Peter Nidditch (Oxford: Oxford University Press, 1978), 86–94.

  55. 55.

    For an overview of the efficacy, promise, and limits of prediction markets, see my “Prediction markets: The practical and normative possibilities for the social production of knowledge”. Episteme 6, no. 1 (2009), 91–106. For a more recent overview of prediction markets, see Erik Snowberg, Justin Wolfers, and Eric Zitzewitz. “Prediction Markets for Economic Forecasting”, Centre for Economic Policy Research Discussion Papers, No. D9059 (July 2012), www.cepr.org/active/publications/discussion_papers/dp.php?dpno=9059

  56. 56.

    ISDA, “ISDA Market Survey Historical Data”, http://www.isda.org/statistics/historical.html; BIS, “Semiannual OTC Derivatives Statistics” (November 5, 2015), http://www.bis.org/statistics/d5_1.pdf

  57. 57.

    Beat Balzli, “How Goldman Sachs Helped Greece to Mask its True Debt”, Der Spiegel (August 2, 2010), http://www.spiegel.de/international/europe/greek-debt-crisis-how-goldman-sachs-helped-greece-to-mask-its-true-debt-a-676634.html

  58. 58.

    Jules Evans, “How Italy Shrank its Deficit”, Euromoney (December 1,2001), http://www.euromoney.com/Article/1003330/BackIssue/50052/How-Italy-shrank-its-deficit.html

  59. 59.

    Gillian Tett tells the story of how the CDS came about at J.P. Morgan in Fool’s Gold How the Bold Dream of a Small Tribe at J.P. Morgan Was Corrupted by Wall Street Greed and Unleashed a Catastrophe (New York: Free Press, 2009), 47–48.

  60. 60.

    ISDA, “ISDA Market Survey Historical Data”, http://www.isda.org/statistics/historical.html

  61. 61.

    BIS, “Semiannual OTC Derivatives Statistics” (November 5, 2015), http://www.bis.org/statistics/d5_2.pdf

  62. 62.

    ISDA, “Greek Sovereign CDS”, http://www2.isda.org/asset-classes/credit-derivatives/greek-sovereign-cds/

  63. 63.

    Alex Barker, “EU ban on naked CDS to Become Permanent”, Financial Times (October 19, 2011), http://www.ft.com/intl/cms/s/0/cc9c5050-f96f-11e0-bf8f-00144feab49a.html#axzz2FF9p4P49

  64. 64.

    Serena Ruffoni, “Wherever Did Europe’s Sovereign CDS Go?” The Wall Street Journal Moneybeat, (January 31, 2014), http://blogs.wsj.com/moneybeat/2014/01/31/wherever-did-europes-sovereign-cds-trading-go/

  65. 65.

    Rene M. Stulz, “Credit Default Swaps and the Credit Crisis”. The Journal of Economic Perspectives (2010), 75–76.

  66. 66.

    Financial Crisis Inquiry Commission, The Financial Crisis Inquiry Commission Report (Washington: US Government Printing Office, 2011), 139–141, http://fcic.law.stanford.edu/report

  67. 67.

    Robert W. Kolb, The Financial Crisis of our Time, 117–124; Financial Crisis Inquiry Commission, The Financial Crisis Inquiry Commission Report, 350.

  68. 68.

    Financial Crisis Inquiry Commission, The Financial Crisis Inquiry Commission Report, 378.

  69. 69.

    Laurent L. Jacque, Global Derivative Debacles, 47–72; 97–102; 143–177.

  70. 70.

    The Economist, “Centrally Cleared Derivatives: Clear and Present Danger”, (April 7, 2012), http://www.economist.com/node/21552217

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  1. University of Guelph-Humber, Toronto, Ontario, Canada

    George Bragues

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Bragues, G. (2017). The Derivatives Markets. In: Money, Markets, and Democracy. Palgrave Macmillan, New York. https://doi.org/10.1057/978-1-137-56940-0_6

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  • DOI: https://doi.org/10.1057/978-1-137-56940-0_6

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