Is the Derivatives Market Dooming Your Financial Future?
by www.SixWise.com

Warren Buffet has called them “financial weapons of mass destruction.” Others have said they’re a form of legalized gambling.

“They” are derivatives, a financial instrument whose value depends on the value of some other asset (including stocks, bonds, currencies, interest rates, commodities, and related indexes) or a combination thereof. In other words, a derivatives value is derived from something else. Rather than actually trading the other asset, derivative traders wager on the future performance of that asset.

"A derivative is a financial instrument whose value is based on something else. It's basically a side bet,” Frank Partnoy, a law professor at the University of San Diego, told 60 Minutes, CBS News.

Two types of derivatives you may be familiar with are futures and options. Futures are a contract to buy or sell an asset (which may be a commodity, currency, security, etc.) at a certain date in the future, at a market-determined price (the Chicago Board of Trade is the largest futures market in the world in terms of value of business and volume).

Options, meanwhile, are a contract to buy or sell a security at a designated price for a specific period of time, regardless of what the market price does.

Why the Derivatives Market is a Risky Bet

Unlike most markets, derivatives have nothing to back them up. They are in essence a “black hole” with no real money behind them and operating completely outside the realm of governments and regulators. Some have even called it a ticking time bomb.

The derivatives market is a difficult one to get your mind around, particularly since it’s value has been estimated at more than $516 trillion, which is roughly 10 times the value of the entire world's output!

At the center of the market is what’s known as a “credit derivative swap” or “credit default swap,” which are private insurance contracts that pay off if the investment goes bad … but that don’t require you to own the investment to collect. The simplest way to put it is it’s like buying an insurance policy on someone else’s house and then collecting on it if their house burns down.

Were Credit Default Swaps to Blame for the Market Collapse?

In the last several years, trillions of dollars in “side bets” have been made on mortgage securities, and whether or not people would default on their mortgages. But these side bets were made in a completely unregulated market, and the banks and investment houses selling them did not set aside money to cover potential losses.

"As the market began to seize up and as the market for the underlying obligations began to perform poorly, everybody wanted to get paid, had a right to get paid on those credit default swaps. And there was no 'there' there. There was no money behind the commitments. And people came up short. And so that's to a large extent what happened to Bear Sterns, Lehman Brothers, and the holding company of AIG," Eric Dinallo, insurance superintendent for the state of New York, told 60 Minutes.

Does This Sound Like it Should be Illegal?

Well, it was illegal up until 2000 with the passage of the Commodity Futures Modernization Act of 2000. Prior to this, in the early 1900s “bucket shops” lined the streets, allowing people to make bets on whether stocks would go up or down. This speculation contributed to the stock market crash of 1907 and the later Great Depression, and laws were put into place to ban the bucket shops.

In 2000, however, a little publicized piece of legislation was passed that removed derivatives and credit default swaps from federal oversight. The Act also pre-empted states from enforcing existing bucket shop laws against Wall Street.

By 2008, credit default swaps had grown to be an over $50-trillion market. Traders and investment bankers began to make billions of dollars as the United States enjoyed the largest financial services economy ever. Many profited immensely from selling mortgage securities and credit default swaps that no one thought would need to be paid off.

"The credit default swaps was the key of what went wrong and what's created these enormous losses," Harvey Goldschmid, a Columbia University law professor and a former commissioner and general counsel of the Securities and Exchange Commission, told CBS News.

Please Share Your Thoughts!

Do you believe derivatives should be outlawed just as they were in 1907? Do you believe the derivatives market is a threat to the U.S. economy? Please share your thoughts on this important topic.

To express your thoughts on the Commodity Futures Modernization Act of 2000 to your elected officials, visit Congress.org and enter your zip code to find your representatives and speak your mind.

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Recommended Reading

What is Deflation, Why Should You be Concerned -- And What Can You Do?

What Type of Investments are Worth Making in THIS Economy?

Sources

CBS News October 26, 2008

Britannica Online Encyclopedia: Futures