-- Posted Friday, 13 January 2012
The term “derivative” has become a dirty, if not evil word. So much of what ails our global financial system has been laid-at-the-feet of this misunderstood, mischaracterized term – derivatives. The purpose of this paper is to outline the origin, growth and ultimately the corruption of the derivatives market – and explain how something originally designed to provide economic utility has morphed into a tool of abusive, manipulative economic tyranny.
Definition of Derivatives
Derivatives are financial instruments whose values depend on the value of other underlying financial instruments or objects. The main types of derivatives are futures, forwards, options and swaps.
The original intended use of derivatives was to manage risk [hedge]; however, now they are often traded as investments whether hedged, un-hedged or as component of a spread trading strategy. 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) — see inflation derivatives — or even an index of weather conditions, or other derivatives). In recent years, much has been written about credit derivatives - which have become an increasingly visible part of the derivatives complex. However, the largest component of the derivatives complex remains interest rate products which the U.S. Office of the Comptroller of the Currency tells us constitute more than 82 % of all outstanding bank held notionals. Interest rate derivatives have a great effect on interest rates as will be discussed later.
Origin of Derivatives
Derivatives have their roots in the agri-complex. From an historical context, it was agricultural commodities futures [mainly grain] that first gained traction as viable financial instruments. The genesis of these products dates back to the founding of the Chicago Board of Trade [CBT] in the mid-eighteen hundreds.
Back in the eighteen hundreds large scale farming enterprises were difficult [risky] to “bank”. The risk was embodied by the known costs associated with planting seed, fertilizing and subsequent growth and harvest – versus the often volatile, unpredictable final selling price of a perishable commodity. Futures removed this this “unknown” from the banking/farming relationship and transferred it to speculators for a nominal fee or cost.
From 1850 - 59, American agricultural exports were $189 million/year [81% of total exports]. With agriculture occupying such a huge percentage of exports and GDP it was only natural that business of this scale [potential fees and profits] would and did attract the attention of the money changers. The advent of futures and forward contracts in the agri-complex was productive: giving a higher degree of predictability to farm income making the business of farming more bankable. Making farm income more predictable enabled the growth of corporate agri-businesses which brought with it economies of scale, the freeing-up of human capital which enabled / translated into mass migration [urbanization] of farmers into cities in part assisting with the rise of the human capital pool essential for the industrialization of America.
Early Growth – the Commodity Futures
In the beginning, as with users in the agri-complex – there were IDENTIFIABLE END USERS [farmers] for these products. Over time, futures and forwards were developed to meet demand in other predominantly natural resource based commodities like coal, crude oil, lumber, cattle and others. Similar commodity futures markets for these products and trade volumes were driven primarily by end users and it’s important to distinguish that for the entire 1800s and virtually all of the 1900s – the growth in derivatives was primarily tied to the commodity trade.
Commodities Law Dictates that Futures Only Aid In Price Discovery
Definition of Price Discovery:
A method of determining the price for a specific commodity or security through basic supply and demand factors related to the market.
According to William J. Rainer, former Chairman of the Commodities Futures Trading Commission [CFTC] back in 1999, Section 3 of the Commodities Exchange Act espouses three basic purposes for the regulatory structure currently administered by the CFTC: (1) to protect the price discovery function; (2) to prevent the manipulation of commodities through corners, squeezes and similar schemes; and (3) to assure an effective vehicle for risk transference. Implicit throughout is the need to provide suitable customer protection from abusive trade practices and fraud.
According to William J. Rainer, former Chairman of the Commodities Futures Trading Commission [CFTC] back in 1999, Section 3 of the Commodities Exchange Act espouses three basic purposes for the regulatory structure currently administered by the CFTC: (1) to protect the price discovery function; (2) to prevent the manipulation of commodities through corners, squeezes and similar schemes; and (3) to assure an effective vehicle for risk transference. Implicit throughout is the need to provide suitable customer protection from abusive trade practices and fraud.
The Rise of Financial Engineering: The Genesis of OTC Interest Rate Derivatives
President Nixon took America and the world off the gold standard in August, 1971. What ensued was a dramatic increase in the price of crude oil which led to burgeoning balances of petro dollars [Euro-dollars] as deposits in the treasuries of banks involved in international trade and a subsequent bolstering of their treasury operations to deal with the influx of ‘inflated dollars’.
Interest Rate Derivatives were developed around 1980. Their basis was the four 3-month IMM [International Money Market] Eurodollar Futures Contracts [Dec, Mar, Jun, Sept] on the Chicago Mercantile Exchange [CME]. These futures contracts are derivatives of 3 month Libor [London Interbank Offered Rate] for Eurodollar Time Deposits. The 3 month Libor rate is ‘set’ daily by a group of banks selected by the British Bankers Association and represents where these ‘reference banks’ are willing to ‘loan’ their mostly recycled Euro Dollars [petro-dollar] to their most credit-worthy customers.
These derivatives/futures gave banks the ability to ‘hedge’ or book profits on sizable amounts of predictable future cash flows. Up until 1980, this bank treasury trading business remained largely a cash trade.
The Toronto - Chicago Nexus
In 1980, Canada revised its Bank Act. In the ensuing few months, Canada had an influx of foreign banks - dubbed schedule “B” banks. Canada went from having 5 domestic banks to having roughly 65 banks in a matter of months. To protect their home turf, the existing domestic banking industry successfully lobbied Canadian politicos to limit the amount of capital new ‘schedule B’ banks could have [initially to 5, or in a couple of instances,10 million CAD].
This placed growth restrictions on foreign banks, new entrants, beginning operations in Canada; capital ceilings implied severe balance sheet restrictions. 60 new banks had just opened their doors – but they were substantially limited in participating in main stream bank treasury operations like lending long and borrowing short - in the inter-bank market because these activities bloated balance sheets.
These new treasury operations needed to find a profitable raison d’etre or their parent banks would shut them down.
Competition Breeds Innovation
To differentiate themselves from the rest of the crowd back in the early 1980’s, particular institutions like Citibank, Toronto and Chemical Bank, Toronto and Chase, Toronto went on a hiring binge of Ph. D mathematician types and immersed themselves in ‘financial engineering’ utilizing then emerging exchange traded futures [cited above]. These financial engineers conjured into existence two Over-the-Counter [OTC] products – Future Rate Agreements [FRAs] and Interest Rate Swaps [IRS]. Trade in these products did not entail the exchange of principal sums between counterparties – only interest-rate differentials on principal amounts [referred to as notional underlying amounts]. The beauty of this “new trade” was a] it was fee based, b] that, for accounting purposes, it was “off balance sheet” and c] it circumvented capital ceiling restrictions.
From a customer standpoint – these products were marketed to corporate customers as a means to achieve cheaper, more flexible funding or alternatives for funding in terms [yrs.] they otherwise would not be able to access.
From an historical perspective - it was during the 1980s when Citibank, Toronto or Chemical Bank, Toronto traded the very first Inter-bank U.S. Dollar Interest Rate Derivative – known as an FRA [Future Rate Agreement] which, at its core – was nothing more than a glorified ‘bet’ on what 3, 6 or 12 month Libor will be at a future date.
It was Citibank Toronto who first engineered a financial model to successfully book accounting profits from FRAs and interest rate swaps.
In the beginning – these trades were ENORMOUSLY profitable – so much so that Citibank Toronto very quickly became the world’s biggest OTC interest rate derivatives house and was, in fact, the clearing house for OTC interest rate derivatives for Citibank worldwide.
This business absolutely mushroomed!
Source: U.S. Comptroller of the Currency
Tracking the evolution of the aggregate derivatives held by U.S. banks, it is apparent that trade in end-user products has been ABSOLUTELY OVERWHELMED by volumes in dealer trades – all in a “supposed market” which is 96% constituted by 5 players [the magnificent 5; J.P. Morgan, BofA, Citi, Goldman, Morgan Stanley] – as the U.S. Comptroller of the Currency tells us in the executive summary of their Quarterly Derivatives Report,
“Five large commercial banks represent 96% of the total banking industry notional amounts.”
At this rate of concentration, the derivatives complex appears a lot more like an “old boys club” than it does “a market”. Therefore, the derivative market rapidly evolved during the late 1990’s to the early 2000’s from a previously end-user-based to a dominantly dealer-based or trading market. The parabolic rise of these dealer traded volumes parallels the rise of market rigging or the movement toward a centrally planned economy.
From Humble Beginnings, How and Why We Got Here
The graph of outstanding notional amounts above depicts a serious growth curve. To explain why, let’s take a look at the same graph with some added highlights explaining “what” is growing so quickly:
Source: U.S. Comptroller of the Currency
Through the late 1980’s and early 1990’s – folks at the Fed and U.S. Treasury – with a little bit of help from academia - realized that interest rate swaps could be utilized to CONTROL fixed income [bond] markets and hence – controllers could arbitrarily determine the cost of capital. As such, it’s no coincidence that institutions like Citibank Toronto had their ‘U.S. Dollar derivatives books’ repatriated back to New York in this time frame.
The Neutering of Usury or “Neusury”
Historically, the Federal Reserve/U.S. Treasury ONLY had control of the VERY short end of the interest rate curve – specifically the Fed Funds rate [the rate at which banks and investment dealers borrow and lend to each other on an overnight basis]. With the advent and proliferation of interest rate derivatives – specifically Interest Rate Swaps [IRS], the Fed/Treasury gained effective control of the “long end” of the interest rate curve. Thus the Fed / Treasury has been practicing an undeclared form of financial repression for a very long time. Read more>>
