This article seeks to define financial derivatives and why they are so important. Future and spot market basics are also examined so the Reader understands how the price of gold and silver is determined.

First, why should we care?

"Derivatives are financial weapons of mass destruction." Warren Buffet, 2003

Good enough. Reader, the term "derivatives" have been bandied about and even demonized by many writers (including myself), so it's best to understand them and their importance. This article will first define derivative, fully answer the above question, and in the third section give a quick lesson on some future and spot market basic terms.

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Modern financial derivatives all started with commodities, namely rice and grain. The earliest recorded financial derivative market I know of came in the early 1700s in imperial Japan at the Dojima Rice Exchange. Although the realm did use coins, they also used rice as another major form of indirect exchange. (Part 3 explained why using rice was a horrible idea.) The samurai stole (or to be more polite, taxed) rice from their serfs, but due to a set of bad harvests and market manipulations by traders, they found their purchasing power to be very adversely effected. A funny way to think of it is that new armor & swords, and lovely geishas were too expensive in terms of rice. Our poor samurai were left scratching their helmets on what to do. (photo)

The samurai decided to sell their harvests forward to stabilize their income. For instance, Joe the Samurai convinces Bob the Trader to give him a set amount of coinage (say 15 coins, or the futures price) in exchange for his rice crop (say 1 bushel) that will be delivered on a settlement day (say 3 months later). When this "futures contract" settlement date arrives, Joe gets the 15 coins, Bob gets the bushel of rice and sells it, hopefully for the price he was expecting to receive, say 18 coins. Joe gets the steady income he desired. Bob makes a tidy profit of 3 coins in return for risking that the price of rice would drop below the spot price on the date he sells the bushel. In other words, Joe the Samurai trades his price risk (the rice's price volatility) for Bob the Trader's basis risk (the difference between the futures price and the spot price). Spot price is the market price for immediate delivery on the day Joe and Bob made the contract).

This process of transferring risk from those without capital to those that do for the possible economic gain of each can enable overall economic growth. However, let's say there is a glut of rice, depressing the price on the settlement date. Joe the Samurai is still happy; he still gets his expected income. However, Bob the Trader will take a loss. Bob the Trader also has the possibility that rice will be scarcer than expected, leading to higher profits for him. Likewise, if Joe does not produce the rice, he has no income, and perhaps also needs to pay Bob the Trader his expected basis risk to compensate for tying up his capital.

Simplified, the term "derivative" refers to a "derived" wager, or bet, on the price of something, in this case rice, at some point in the future. However, I will add this was not an idyllic process for the Japanese; it was full of starvation, riots, monopoly traders, and messy government intervention. Severe economic inefficiency where a select few profit, sound familiar?

However, I want to point out that derivatives are by no means "evil" in this respect, no matter how much disgruntled modern-day traders and economists demonize them. It is also important to recognize that these primitive "derivatives" always consisted of wagering on something with intrinsic value, like a commodity.

Now a formal definition:

Derivatives - financial contracts or instruments, whose values are derived from the value of something else, which is termed the "underlying." The main types of derivatives are futures, forwards, options and swaps.

The main use of derivatives is to reduce risk for one party. The diverse range of potential underlying assets and pay-off alternatives leads to a wide range of derivatives contracts available to be traded in the market. Derivatives can be based on different types of assets such as commodities, equities (stocks), residential mortgages, commercial real estate loans, bonds, interest rates, exchange rates, or indices (such as a stock market index, consumer price index (CPI) or even an index of weather conditions).

Credit derivatives have become an increasingly large part of the derivative market. These are financial contracts that explicitly shift credit risk from one party to another. Instruments include over-the-counter (OTC) credit derivatives, such as credit default swaps, total return swaps, and credit spread options.

Credit default swaps are probably the most infamous credit derivative. These enable lenders to a company to purchase what amounts to insurance that will protect them if the company defaults on its debts.

There are two kinds of derivatives

Over-the-counter (OTC, or direct buyer-to-seller) derivatives are contracts that are traded and privately negotiated between two parties. All OTC derivatives are unregulated, so the counterparty risk is the key factor: basically, when the contract terminates will one party stay solvent and reimburse the other without going bankrupt? According to the BIS, the total outstanding notional amount is $684 trillion as of June 2008. Of this total notional amount, 67% are interest rate contracts, 8% are credit default swaps (CDS), 9% are foreign currency exchange contracts, 2% are commodity contracts, 1% are equity contracts, and 13% are other assorted types.

Exchange-traded derivatives (ETD) are those derivatives products that are traded on regulated exchanges or markets. The exchange acts as a public intermediary for all transactions, and takes on the counterparty risk for a fee. As such, the exchanges pay close attention to all party's solvency, so party defaults are less likely than on OTC derivatives. According to the BIS (pg 108/116), the total outstanding notional amount is $77 trillion (as of June 2008.)

And now the reason for Buffet's concern becomes clear. As the world's reserve currency, the majority of all derivatives are transacted in dollars. And these trillions of dollars of worthless fiat electrons truly dwarf the rest of the world.  I can show you and I bet I do not even need a graph!!

• ~8 Trillion Total Monetary Supply of US Dollars, cash, coin, and banking accounts <$100K (Federal Reserve M2)
• 15 Trillion Total US 2008 GDP, or the market value of all goods and services by all American parties
• 50 Trillion Total world GDP in 2008 per US Global
• 75 Trillion Total value of the world's Real Estate per US Global
• 77 Trillion Total nominal value of world's ETD derivatives per BIS
• 100 Trillion Total value of the world's stock AND bond markets per US Global
• 684 Trillion Total nominal value of world's OTC derivatives per BIS

[See slides 4-9 of this August 2008 presentation from US Global Investors]

So the key is that due to their massive size and inherent risk, derivatives (primarily OTC), have the potential to deliver  truly staggering losses that could ripple through the rest of the financial system like a bullet train with no brakes down the slope of Mount Everest.

I think the basic trouble behind modern-day derivatives can be summed up rather succinctly. Many of today's derivatives are wagering on paper "assets" that have no intrinsic value. To wager on freely traded tangibles like corn or wheat on a commodities exchange with counterparty risk protection is one thing. To wager on paper "assets" like interest rates of a GE bond, a Fannie Mae mortgage, or the fiat Australian dollar without counterparty protection from fraudulent balance sheets, themselves consisting of fiat electrons, is pure madness.

Why and how did the mess get this big? Super briefly, Alan Greenspan of the FED decided to not regulate OTC derivatives 10 years ago. Following this decision, they mushroomed. My personal root cause analysis is that many of the traders doing the deals have no idea what makes money money, nor did they 100% understand what they were transacting, and were lured by the "miracle" of leverage and the siren song of "risk-free" profits, a complete misnomer.

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Future and Spot Market Terms 101

Spot price is the market price of a commodity for immediate delivery. Cash is slapped on the barrel and the goods forked over right away.

Futures contracts buy or sell a standardized quantity of a specified commodity of standardized quality (which, in many cases, may be such non-traditional "commodities" as foreign currencies, commercial or government bond, or "baskets" of corporate equity) at a certain date in the future, at a price (the futures price) determined by the instantaneous equilibrium between the forces of supply and demand among competing buy and sell orders on the exchange at time of purchase or sale.  Fancy talk for the futures price fluctuates all the time via a bid-ask system and includes storage and finance fees.

Contango occurs when the futures price is greater than spot price. Physical commodities (such as gold and silver) typically have a higher futures price since the holder is responsible for carrying costs.

Backwardation occurs when the futures price is less than spot price. For physical commodities (such as gold and silver) this situation is typically remedied since parties holding the commodity sell it for spot and then repurchases the "paper" commodity back at the cheaper futures price.

Basis is the difference between the futures price and the spot price. When futures are in backwardation, they are said to have a "negative" basis, while in contango a "positive" basis.

Long position is the party who agrees to receive a commodity.

Short position is the party who agrees to deliver a commodity

To exercise your knowledge of these terms, I suggest reading Dr. Antal Fekete's article "Keeping Our Eyes Peeled For The Silver And Gold Basis" and my article "The End for the Dollar and all Fiat Currencies - A Money Matrix Addendum".

If I failed to explain simply enough (please write below and say what I could have done better or if I made any mistakes) try "Futures Fundamentals: How The Market Works" from investopedia.com.  The Federal Reserve Bank of Boston also publishes a decent explanation of financial derivatives here "Tools of the Trade: A Basic Guide to Financial Derivatives."

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 - Pennywise, "Time Marches On" from their Land of the Free? album

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Part 11 - Bring Light to Dark Derivatives!

WASHINGTON D.C. - July 24, 1998, was an epic day for the global financial system. Federal Reserve Chairman Alan Greenspan stood before Congress's Banking and Financial Services and testified. This article and the next part will focus on these two excerpts from this testimony.

"In conclusion, the [Federal Reserve] Board continues to believe that, aside from safety and soundness regulation of derivatives dealers under the banking or securities laws, regulation of derivatives transactions that are privately negotiated by professionals is unnecessary."

"Nor can private counterparties restrict supplies of gold, another commodity whose derivatives are often traded over-the-counter, where central banks stand ready to lease gold in increasing quantities should the price rise."

In his testimony, Greenspan recommended to Congress that regulation of Over-The-Counter (OTC) derivatives between private parties was not necessary. These derivatives are referred to as "dark derivatives" as they take place away from exchanges where the terms could be made public and the companies examined by the exchange for counterparty risk – the risk that a company would be insolvent or bankrupted by the time when the derivative comes due. For instance, the metal commodity markets like the NYMEX require a 100% cover of all deliverable contracts (leverage transactions still require a 90% cover per 17 CFR 31.8), and examine the solvency of both parties. The remainder of this article will delve into the consequences of this action.

Less than two months after Greenspan's testimony, the failure of the hedge fund Long Term Capital Management nearly deflated the developing stock market bubble as it took $4.6 billion USD in derivative-based losses. The Federal Reserve leapt to the rescue, leading a cabal of investment banks to pony up $3.6 billion USD. Goldman Sach's CEO Jon Corzine was forced out shortly afterwards by the future Secretary of the Treasury, Henry Paulson. Corzine would move on to become a US senator and is the current governor of New Jersey. Bear Stearns refused to cooperate and later became the first major casualty of the Panic of 2008.

Greenspan's second comment was that central banks would act to suppress the gold price by releasing central bank gold into the market was quite similar to what the London Gold Pool of the 1960s had attempted - and miserably failed – to do: control the price of gold. This is tantamount to stating that the financial "canary in a mine" would be both hooded and castrated in public view. Even in today's troubled economic times, most members of the public are completely unaware that the 2008 daily trading on the London Bullion Market Association exceeded $80 billion USD per trading day, or $20.3 Trillion USD for the year. Part 12 will delve more into the suppression of the gold price, building off of the excellent work put together by the Gold Anti-Trust Action Committee, or GATA.

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Bring Light to Dark Derivatives!

First, let's see what has happened with the OTC derivative market since 1998. The short answer is that the value of the notional amounts exploded from $72 Trillion to $684 Trillion in June 2008 per the data provided from the Bank of International Settlements, or BIS.

Before moving on, let's add one more definition to the list from Part 10, "What the Heck are Derivatives?"

Notional Value - the value of a derivative's "underlying assets" at the spot price. In the case of an options or futures contract, this is the number of units of "underlying assets" specified in the contract multiplied by the spot price of the asset.

Let's say I wanted to speculate on the price of crude oil. I could buy an October 2009 contract to deliver 1000 barrels at $60 a barrel plus exchange fees. The notional value of this contract when purchased is $60,000 but it will not be exchanged until October. In the meantime, if the spot price of the oil drops to $40 per barrel, the notional value drops to $40,000. Furthermore, although the contract gives me the right to buy the oil, I am not the owner of the oil until October arrives and the contract is delivered. The oil is the "underlying asset" of the contract.

The same could be said for a credit default swap on a corporate bond, a swap based on the dollar's interest rate. Or a "mortgage-backed" collection of securities. As you can see, the "underlying asset" can be physical property like the barrel of oil, but it could also be much more nebulous, like a derivative based on the ability of hundreds or thousands of people to collectively pay their mortgage on time. Plus, how much are these written contracts actually worth while they have not been exchanged? Well, the BIS gives this information which I used to make the below chart on "gross market value." This grew from $2.5 Trillion in 2008 to "only" $20.4 Trillion as of June 2008.

Interestingly enough, the BIS also placed a "market value" on "gross credit exposure" of $3.9 Trillion in June 2008.  This is the leftover amount after taking into account all contracts that offset each other.  Theoretically there is a long contract for every short, but per the BIS this is not always the case. (I do not have specifics yet but this may involve leveraged transactions).  So this amount signifies the "market value" of those derivatives where there is a possibility of totally unhedged losses.  I must state it's not appropriate to do so other than to obtain a rough idea, but if the percentage of the gross credit exposure could be estimated as proportional to the nominal value, this would work out to a whopping $130 Trillion.

However, how can you place a "market value" on all the various types of derivatives? Most especially, how can you call this a MARKET value if there is NO market for these contracts – remember that all OTC derivative transactions take place directly and privately between a buyer and seller.

The Paper Property System and Derivatives

This requires us to look at the derivatives problem in a new light. The crux of the matter is that OTC derivatives have an unknown worth – the BIS "gross market value" calculation is, in my humble opinion, nonsense. Let me explain.

First one should understand that our entire property system is founded on paper documents. If one owns a car or a house in the United States, one must also have a deed or title to that property. If one buy goods from a store, there is a paper record – a receipt – that serves to transfer ownership of the good from the store to the individual. Online transactions merely substitute screens for this paper record. Whether a corporation or an individual, one typically has to prove their identity in some way based on paper – a passport or driver's license or business license – before doing business with each other. The vast quantity of transactions we execute are done with unseen other entities. Also recognize that when you purchase or sell a stock share or mutual fund share you are selling it to an unknown person, usually via some exchange that you trust to transfer your property – which is really just a paper document.

This system of property identification and organization is founded on our rule of law. However, many fail to realize that this link of property to paper documentation does not exist in many places in the world – many Latin American and Third World countries do not have a very clear, transparent property system setup. However, the size of the OTC derivative market has led the modern-day United States into a similar Third World scenario! We do not understand (and have lost) the link between the paper derivative contract and real assets.

Furthermore, we no longer know if these pieces of paper has any worth and are tethered to real assets with actual value. All derivatives are really instruments of quasi-property. These credit instruments pretend to be based on (fiat) money, but they are not really anchored to anything!! They masquarade as real property, but at best are just forms of quasi-property.

Remember, we live in a paper property system. Without the knowledge on what these investment bankers and their financial engineer assistants have done, there is no way to know if they are bankrupt. Let me repeat. THERE IS NO WAY TO KNOW FOR SURE IF THESE COMPANIES ARE SOLVENT.  There is no way to know if its even POSSIBLE for the government or FED to help a few banks or companies if we do not understand what these troubled companies really possess. Executing on eco-political policies and ideas like one "big, bad toxic bank" is an inane idea since – I cannot stress this enough - we do not have the information to know whether these actions will help or not. Which derivative contracts are the "toxic" assets? Where are they? Exactly what assets are they based on? Who owns them? Which counterparties are solvent?

The Pregnant Economy's Credit "Baby"

Think of the world economy as a pregnant woman. From the outside, we can examine its monetary structure and all the goods and services it produces, but we cannot view the credit hidden inside the woman's belly. (photo from petercanfail)

Without testing with an ultrasound or checking for movement, we do not know anything about the baby.

1. Perhaps the baby is in perfect health.

2. Perhaps the baby's head is too large and Caesarian needs to be performed or perhaps the umbilical cord is wrapped around the baby's neck and will choke it if delivered normally.

3. Perhaps the baby has already died. (I hope not!)

The horse I am beating to death is that it's impossible to know if a cure is needed and what the cure should BE if the information of this "shadow economy" is not being shared. When $684+ Trillion dollars (possibly past $1 Quadrillion as this is based on September 2008 numbers) is involved, we simply must have the information if we are to move forward.

There is no way for the economic crisis to end without understanding the actual worth of these derivatives. Let me repeat again. THERE IS NO WAY FOR THIS CRISIS TO END WITHOUT UNDERSTANDING THE TRUE WORTH OF THE DERIVATIVES MARKETS. Light must be brought to dark derivatives because there is no confidence in the value of both the derivatives but to some extent even to all assets. Mark my words, the world will remain in a state of unease, in a state of endless price discovery, until light is brought to the OTC derivative mess.

Now, if the OTC derivative market did not have high degrees of insolvency, it stands to reason that all information would already haven been available – and the world would not be in crisis, Lehman Brothers and Bear Stearns would not have failed, the major banks like Citigroup and Bank of America would not have been halfway nationalized, and the remaining investment bankers and commercial banks like Merrill Lynch, Goldman Sachs, JPMorgan Chase, and HSBC would have been able to carry on business pretty much as usual, regardless of the subprime mortgage crisis. Therefore, the credit "baby" is not in perfect health.

Therefore, the question becomes how bad is this insolvency? Can the credit "baby" survive with an operation or not? Is it "just" several mega-banks that will be insolvent? Or is the credit "baby" dead-on-arrival and the entire financial system will come crashing down, as was feared during LTCM in 1998, and during the Lehman Brothers/Bear Stearns aftermaths of 2008?

Of course, we have made a bit of a circle, as there is no way to know the answer to this question without the information. My opinion is that what seems to have occurred is that the banking cartel is attempting to weather the storm by frantically repairing its balance sheets with bailout money from a compliant Congress or bailout money from the FED. However, the problem does appear to be fairly catastrophic as the losses for certain banks are most likely too large to paper over with bailout money, and credit extended from by other banks has dried up as they are (rightly) extremely worried about counterparty risk.

No Relief from Past or Future Banker Bailouts

Let me repeat. The bailout money issued by Congress to the AIG, Citigroup, etc. is almost certainly too small to have any effect on the derivatives problem. $750 Billion, $787 Billion, $2 Trillion bailouts are like throwing pebbles into the ocean when compared with $500 Trillion to $1 Quadrillion. Look at their asset to nominal value ratios and percentage of OTC "dark" derivatives below and please inform me if you come to a different conclusion and why. (Data from Department of Treasury's December 2008 OCC report, page 24/33)

Transferring enough paper dollars from hard-working taxpayers either in the present or in the future to these ill-run banking companies can only result in a dollar currency crash similar to what happened in Iceland or many Latin American countries during the '80's and '90's, and hence the (further) impoverishment of the American people. As others have written, this is truly a privatization of the 1998-2007 gains and socialization of 2008-and-onward losses for the banking and investment banking cartels.

The Future

Obviously for a future resolution to occur, Greenspan's actions should be reviewed in hindsight, the informational deficiency needs to be made transparent, and companies that survive and have not committed fraudulent acts should be penalized by the marketplace for carrying out too sizeable over-the-counter deals without seeking an exchange to verify and secure the counterparty risk. Turning to the future, all involved should consider instead to focus on the true wealth production of goods and services, not questing in search of "riskless" paper-shuffler profits like the financial engineers of the past decade.

Of course, this discovery will eventually happen naturally in the United States - unless we enter a totalitarian society and are led to war by our leaders to either control or confiscate even more of the world's wealth but also to refocus the populace on both interior and exterior scapegoats for our fiscal problems. Again, there is simply no other way for our economy to function again on a non-war footing without this information from the financial companies. Of course, the wars will do nothing except worsen the state of economic suppression everywhere in the world, including for most Americans, except for the few elite who may prosper.

Taking the optimistic view, there is no way to know when this discovery will happen, and as much as I believe in the "separation of business and state" the fact of the matter is that the political will of Congress must be brought to bear on the banking cartel led by the FED. There are some encouraging signs. In early April, the FED urged its major cartel members and hedge funds to list their credit derivatives on an exchange in New York City.  Congressman Ron Paul's Federal Reserve Transparency Act of 2009, HR 1207, has now reached 58 co-sponsors.  This act will enable the American people to audit the FED.

Answering Questions Posed from Part 9

Q: Although many Austrian economists makes perfect economics sense from the standpoint of monetary economics, do their analyses hold up from the standpoint of credit economics?

My answer: Not necessarily. In fact, credit economics most likely answers why their predictions of hyperinflation and massive dollar devaluation have not yet occurred.

Q: What occurs when credit contracts, causing credetary deflation, while monetary inflation continues?

My answer: They act as opposing forces. When both credit and money supply inflation were occuring during the earlier part of this decade, price inflation was indeed seen. In fact, up until July 2008 commodities were on an upward parabola. Credetary deflation may have caused commodity price deflation. In our contemporary time of near-zero or dropping interest rates, definite and measurable monetary inflation, and continued (but unmeasurable) credetary deflation, it is easy to predict plummeting manufacturing and service-related job losses. Consumers have slowed purchases of homes, autos, and non-essential goods since many are uncertain in what the future will bring. Economists cannot make meaningful predictions without bringing light to the dark derivative market, but even then numerical answers will not exist due to the Misesian theory of human action.

Q: What happens when we lose track of the value of these paper credit instruments that are in fact forms of quasi-money?

My answer: Historically, when property, money, and credit become out of balance, panics or depressions occur. Again, we will likely stay mired until this quasi-money is fully or mostly accounted for.

Q: What can the average citizen do?

My answer: Well, besides continuing to read the Money Matrix series (grin) it's important to stay optimistic, educate yourself, become politically-active if you wish and enjoy life. In uncertain times, its best to conserve funds as much as possible, and it's never to late to start saving if you plan a future for yourself and your family. Any private debt needs to be dealt with in a rational manner. If continued price inflation or even hyperinflation (subject for another article) appear imminent (it does not appear so to me at present), what is slightly paradoxical is that being in debt will be of great advantage as currency devaluation reduces the principal of the debt's purchasing power. In the meantime, private individuals should consider diversifying savings from the fiat dollar currency into hard money, namely gold and also silver to avoid fiat currency risks. As explained in this series "The End for the Dollar and all Fiat Currencies (1/5)", the derivatives market sets the market prices for gold and silver, but if this crisis of confidence worsens, these assets are by far the best money to hold.

Postscript - I was delighted to hear South American economist Hernando de Soto discuss this at mcalvany.com and has published several articles on this subject, including this one from the Wall Street Journal as well. It may not take a genius to realize that Greenspan made a big mistake, but its nice to hear a fairly mainstream guy recognize this as well. In particular I recommend the McAlvany audio as de Soto is far more knowledgeable, educated, and easier to understand on this subject than me.

"Some say the end is near.
Some say we'll see armageddon soon.
I certainly hope we will.
I sure could use a vacation from this!!"

-  Tool, "Aenima" - Time to end the wait to see which of the dark derivatives will hold water and which will need to, as Tool puts it, "learn to swim."

The Money Matrix Series

-- Posted Wednesday, 8 April 2009 | Digg This Article