I got tired of reading articles on derivatives what say more or less the same thing: that derivatives are so many, too many, are obscure, are dangerous.
Since the outbreak of the crisis, the literature on derivatives competes with that of the conspiracies, the quantity and the ability to say everything and its opposite. There are those who paints the derivatives as the source of the ills of humanity, strong in the fact that for the most part, these are exotic instruments and therefore incomprehensible to the general public. Some say that instead are an important tool for risk management and the production of liquidity .
Rarely, however, I read the most important thing. That is to say that derivatives are part of the global financial architecture for thirty years and their development has been the consequence of the creation of a new payment technology : the intraday credit, which has revolutionized the international payment system. Derivatives, in short, would never have been able to develop so much if they had not been behind a banking system capable of supporting them.
All those who complain of derivatives, in short, tend to exchange finger with the direction. The epiphenomenon, with the phenomenon.
They would do better to complain if they have to, the abnormal level reached by the credit (debt) to GDP globally. But if they did, they would also say that just such abnormal development has enabled a level of well-being for many parts of the world than ever before in history.
Tout se tient.
Elsewhere I have already talked about the difference between legal money and bank money . The latter led the credit’s expansion, and therefore liquidity in the last three centuries. But the great leap started in the late ’70s, when the wave of liberalization of capital has resulted in what historians call “financialization” of the economy, further innovated, accelerating it, the process of creation of liquidity, forcing us to rethink all the mechanisms of regulation and control. If you skip this process, you do not understand what is beneath the derivatives and why they are systemically important.
I take a small step back. In 1973, two economists, Ronald McKinnon and Edward Shaw, introduce the concept of “financial repression” to characterize the state of the financial systems in the world, where there were strong restrictions on entry in the banking sector and controls on capital movements.
The era of stagflation, that characterized the ’70s, had as a consequence the reaction to this, which culminated with the process of liberalization, which took effect on banking and on the movement of capital.
Start the explosion of credit that the graph titled this blog illustrates better than a thousand words.
For the financial world is the beginning of a revolution that finds his best tool in the derivatives, since they are very flexible and easily replicable.
The idea behind these products, namely the “commoditization risk” and therefore the possibility of distributing selling them, effectively, is successful. In the mid-80s, derivatives were still “invisible”. In the mid-90s their notional value exceeded 20 trillion dollars. At the beginning of the XXI century we were already over 85 trillion. In the middle of last year, according to data from Bis, we arrived at about 670 trillion dollars, plus or minus ten times the GDP of the world.
This explains why we speak so much. While we never hear of their systemic implications.
The problem is that this mountain of debt must be supported by a financial infrastructure that should allow it to circulate and payment. Especially when such payment is mostly set within of 24 hours.
And here we come to the point: the explosion of the volume of the derivatives is directly linked to the development of the credit intraday, namely a mode of credit that, unlike the simple bank credit, is much more concentrated and much more opaque. Banks’ balance sheets will only display the records of these “days lived dangerously” in the form of profits or losses. But few know how to behave while they operate.
What we should know, in fact, and rarely we are told, is that now the vast majority of transactions begin and end within the business day. This new approach, to be sustained, it needs to be able to count on sufficient liquidity, otherwise a disastrous credit crunch. We have seen just the intraday credit freeze in the terrible days of the start of the financial crisis.
Since that moment, would have gone bankrupt Lehman Brothers.
The intraday credit, therefore, is the last frontier of innovation credit. The real innovation that has changed the banking history. Comparable to the first banknote or the first deposit.
Some studies show that in the decades in which the volume of derivatives grew level, the demand for money for the purpose of settlement, in relation to GDP, remained stable while growing the overall quantity of money. The only possible explanation, therefore, is that the increase in this volume has been supported by an increase in the speed of movement of the coin. I remember that, according to the quantity theory of money, the money supply is calculated by multiplying the money supply to the velocity of circulation.
But if it increases the speed of movement, means that grows the number of transactions. It implies an exponential increase in transactions that are increasingly shorten the time span in which they take place. That’s why the exponential increase in transaction has paid unusual development of intraday credit, category already existing before the 80s, but still “sleeping”.
To make it simple: Derivatives are gasoline, intraday credit car. But the car without gasoline would not exist. Contrary to what happens in the real world.
The precondition for this development of the derivatives is possible, however, is that they are always perfectly liquid. What, then, there is always someone who will buy. This implies that at any time who is called to mediate these operations has a chance to draw constantly to large supplies of cash to settle their slopes. And the only source capable of ensuring such a cornucopia are the central banks.
Central banks support the intraday credit, which could be represented as a mountain of interbank transactions intended to be opened and closed during the business day. And they are the ones at the beginning of this process, that must take the load smoothly. In the course of a business day, in fact, it may happen that many banks being exposed to much higher than the value of its assets. And if something goes wrong, is the central bank that needs to find a solution.
History provides few examples. In 1985 an issue of miscalculations put the Bank of New York, a bank that operated in the market for U.S. bonds, wasn’t able to close the commitments made in the course of the day. To avoid disruption, the Fed increased the monetary base by 10% in one day, using as collateral the entire active sheet of the bank.
Since then many things have changed, but the essence remains the same: the intraday credit between financial operators has become the main factor in the risk / benefit of those who turn the money. Were refined processes of regulation, and the central banks have started to get paid (it was free) for liquidity that provide financial operators, even in the face of the payment of guarantees (before it was not necessary). But above all, have established definitely the clearing house, or central counterparties, if you prefer, that they ended up becoming the protagonists of this mountain of daily transactions.
These entities have the task of ensuring the liquidity of trading in the derivatives market, but now also of equities, assuming the risk of default, but at the same time increasing liquidity in the market. In Italy, for example, by the Compensation Fund and Guarantee Fund, a subsidiary of the Italian Stock Exchange, while abroad there are giants such as the European LCH.Clearnet and Eurex or the American CME group.
These giants guarantee every day huge volumes of trade on their platforms. They take the risks and the relative huge profits. Because another thing that seldom remembered, when we talk about derivatives, is that they are a huge source of profit, not so much for those who buy them or sell them, but for those who make them turn around.
This Eldorado raises many appetites. Recently, the Financial Times reported the cry of alarm raised by some international banking groups, according to which the clearing house would not be capitalized enough to withstand the impact of the rising tide of transactions that are required to provide.
Moreover, the specific weight of the clearing house is substantially increased after the outbreak of the crisis, when international regulators have started to focus on their development to avoid loading the usual risks of large banks, already heavily exposed. The same people who today complain that such risks would not be sustainable by these central counterparties because undercapitalized or because they accept bonds as collateral for margins.
At stake is the cake of the derivatives over the counter (OTC) , that regulators would be brokered by the clearing house and that the banks would rather keep to themselves, since they represent the majority of notional volumes outstanding and the largest source of profit.
On all this flutter the central banks, which are struggling to keep their liability on the payment system, put to the test by the explosion of intraday credit in the face of temptation creeping privatization that comes from large international banking groups.
As you can see, times change, the speeches are becoming more complicated, but the story is always the same: you will still want to make money with money and you fight between entities to decide who touches the lion’s share.
These processes, it is worth to notice, are discussed and decided at increasingly supranational entities, technical and legal, to nothing to do with the classical mechanisms of political representation.
Make money with money, without any democratic control.
Perhaps this is the real problem.
Not the derivatives.