A Financial Explosion

The odds have shifted nowadays toward a more bearish endgame.  What has happened is a veritable financial explosion, one that puts financial markets at great risk.

Turbulence has become likely at this time because of the huge increase world-wide in derivatives.  By way of explanation, derivatives are investment contracts in which the price is derived from the value of underlying assets.  They include futures contracts, options, and so-called swaps.  Their intention theoretically is to reduce risks, but also to achieve speculative profits.  They can produce outsize profits and losses.  Hence, in place of owning, say a share of a common stock in a company, you buy a derivative whose purchase does not require so much money, like buying a stock on margin.  If the derivative goes up in price, the percentage gain is large, and conversely, a decline would entail a significant drop in its value (price).

That being said, it should be noted that derivatives have reached the astroniomic level of $440 trillion (not billion).  That is over three times the entire global economy.  Some claim that the risk-distribution benefits of derivatives outweigh the risks.  There is a lack of information about who ultimately owns the derivatives and the probable concentration of ownership.  (Only a few are involved in this type of speculation, so the number of "players" is small.)  Some say never mind the existing pitfalls.  Despite that, concerns are so potentially great that derivatives could well be a blunder of tragic proportions.

In the late 1990s, Nick Leeson, a trader with Barings Bank, brought down that institution, which was founded in 1763.  It survived the Napoleonic Wars, the two World Wars, and the 1930s Great Depression.  Yet, Leeson’s trades, which amounted to a few hundred millions of dollars, ended in disaster, and bankrupted that vernerable organization.  In Rogue Trader Leeson blamed the failure on the inability of anyone to keep track of all his manoeuvres; according to him, it was not feasible for any person to follow or unravel all these schemes.  Time magazine simply said that the "financial instruments called derivatives were responsible for destroying a 232-year-old bank."

In view of that debacle, one must be alarmed at the difficulties involved in keeping track or disentangling $440 trillion of derivatives.  It is beyond the capacity of any person or group.  A major Canadian bank has an entire floor filled with traders involved in such undertakings.  Does any manager have the expertise to know who owes what and to whom?

The Canada Pension Plan recently was given permission to "invest" in derivatives.  Ottawa should assume more responsibility to curb this speculative mania before it brings a major financial debacle.

Bruce Whitestone