The Virtual World of Derivatives: The Art of Gaming the U.S. Financial System

    

        The job of a derivatives trader is like that of a bookie once removed, taking bets on people making bets.

                                                                                                                           - Linda Davies

Price Discovery

Referring to the close proximity of investment bubbles in stocks, housing and oil, NBC commentator Steve Liesman said that it was as if we had three 100 year floods all in less than 10 years.   Calling the collapse of our credit markets a 100 year event, Alan Greenspan used a similar metaphor to describe the carnage. 

While these metaphors are useful in understanding the severity of our situation, they obscure key points and suggest chance and accident to what is otherwise a systemic problem.  The notion of accident conceals evidence to where the roots of our current crisis may be identified:  price discovery and equilibrium.

Soviet and Chinese brand Socialism failed in part because price did not effectively respond to fluctuations in supply and demand, leading to constant over or underproduction.  Free market capitalism in America and England is failing for a similar reason, destabilizing the economies of the world.

Formerly it was understood that price discovery was modulated by supply and demand and the cost of production.   Today the ruling order of financial markets has been short circuited by the cycles of fashion, the operative logic of the art market, and the imposition of a system of exchange, via financial derivatives, that is closer to gaming than investment.   Meantime, the decision making mechanism for both production and consumption are governed largely by codes and statistical models divorced from social purposes from which they evolved.

The Evolution of Value

In the natural state of exchange, speculation is minimized by a reference to labor time and cost of production.  In primitive economies up until the last century, the cost of items exchanged chiefly reflected labor time.

So important was labor to the early model of capitalist production, Marx laid the foundation of his capitalist critique solely upon the antagonism between labor and capital.  But this was only an inaugural mode that is surpassed in the new economy that produces value from communication, images, and meaning.  Value creation in the new economy rests well beyond both the Marxist and liberal interpretation of production.  The evolution of brands as a chief determinant of price and value marks the transition of value beyond its natural state of use and function to the governance of codes and signs.

Fashion brands represent the most legible instance of an economy of signs divorced from use value.  The logic of fashion - the need to sell an item faster than it wears out - has permeated the general economy.   Everything from clothing, automobiles, and even household appliances are ruled by fashion cycles determined primarily by superficial changes, creating both faster economic growth and additional environmental waste.   

Fashion increases price volatility as it decreases the life span of objects by way of psychological obsolescence.   Over time, the cycles of fashion move beyond consumer objects to impose its form on investment.  Wall Street firms generate transient investment themes to create a fashion system of investment, marginalizing the traditional descriptors that classically trained economists are dependent upon, rendering much of their analysis unreliable. 

The influence of the principal of art upon the commodity represents an additional force of disequilibrium.  Andy Warhol's 1962 painting of a Campbell's Soup can captured the essence of the

commodification of art and the imposition of aesthetics upon the commodity.   As the value of securities became more closely tied to the subjective and compromised opinions of analysts and rating agencies, Wall Street banks become more closely aligned to the world of art than the notion of commerce described by Adam Smith or Milton Friedman.  It is a system too easily manipulated for the benefit of insiders at the expense of its nominal participants.

Financial derivatives are merely the last chapter in an economy that has transitioned from a natural state of exchange related to use and function to a virtual one, lacking reference to the real world, detached from needs and meaning.   The derivatives market is something more extreme, beyond needs and meaning.  It is a market of absolute speculation.  A world far away from the industrial titans of old that produced tangible goods of use and social benefit.

Matrix of Value                                                                                                                                                                                                                                                                                                                 

                                                                                                                                  

Commodity         Type	Price Discovery	Autos	Clothing	Investment	Speculative        Value
Standard / Branded	Use or Function / Sign	Base Model / BMW 325i	Pullover Shirt /  Polo Pullover	Price referenced to fundamentals / Precious metals and stones, fiat currency (price reference to scarcity or abundance/ sign)	Low to Medium / Medium
Fashion	Cyclical value determined by Sign	Brand of the   car, shape	Brand of the clothes, cut of the cloth.	Asset class, investment theme	Medium to High
Art	Abstract value determined by insiders and critics.  Creation of scarcity.	Antique, Specialty, or Limited  Production	Limited Edition Designer Clothing, Vintage or Couture	Investment Banking Analysis, Ratings Agencies, Insider Trading	Medium to High
Gaming	Determined by shared rules			Financial Derivatives	Absolute

Chart Summary:

The price discovery system of classical economics sufficiently describes standard goods or services.  Branded goods that are sold for "sign" or status value, fashion, art, and gaming are more often unstable and irrational systems of value creation, resulting in a mismatch between price behavior and analytical models. Fashion acts as an accelerator of change, causing quicker turnover of assets and more movement of money.  Art functions more as a contrived or rigged system than an efficient marketplace, where critics, art houses, and insiders dominate pricing and movement of assets.   In every instance, references to traditional models are maintained, although they may in fact be secondary or tertiary drivers to price.   

Viewed this way, fresh perspectives regarding value emerge:   How much value is relegated to the status of an item?  Is it in fashion, or out?  What do the critics say?  And who are critics and credit agencies working for?

In our contemporary "free market" system, securities analysts employed by Wall Street firms influence pricing in a manner more aligned with art critiques than investment analysis.   Investment banks act to influence price and value as dominant art houses and fashion brands, acting as deciders of value and initiating trends.   Ratings agencies exist beyond the realm of traditional interaction that determine price and may in fact block efficient price discovery and market interaction.  The rules governing financial derivatives may be arbitrary and divorced entirely from any physical delivery, possession or ownership of an underlying asset.  Money may trade hands without creating value, resulting in a specious form of exchange that serves no purpose.

When the virtual wealth of financial derivatives exceed the material wealth of the world, an ultimate wager had been created, something previously unimaginable, an all or nothing exchange.  

                                             Welcome to the Desert of the Real.

                                                                                            - Jean Baudrillard

Financial Derivatives

Derivatives may be defined as financial instruments that have no intrinsic value, but derive their value from something else.   In the past they were primarily used to hedge the risk of owning things that are subject to unexpected price fluctuations, e.g. foreign currencies, bushels of wheat, stocks and government bonds.   More recently derivative contracts were put in place to at least superficially attempt to "insure" against risks of loan default, hence the name "credit default swaps."

What in fact they represent is an immense wager whose bets came to dwarf the entire economy.   Credit default derivatives came to represent  roughly $62 trillion.   This compares roughly to $1 trillion in subprime mortgages and a $7 trillion dollar total for the entire U.S. mortgage market.   This swap market has remained so far unregulated while bets against mortgage securities have made incredible payoffs.  However a point was reached when those selling insurance on these instruments could not pay make good on their side of the bet.   AIG was one of the largest insurers of credit default swaps and failed as a result of too many loans defaulting once.  

The derivatives market grew so large that already by the year 2000,  a point was reached where the total value of derivatives exceeded the total of U.S. wealth.   Seven years later, this number would exceed the total value of world wealth, creating stakes so massive, that the entire wealth of the world had been wagered to theoretically reduce risk while creating exorbitant fees for investment bankers and alpha (above market returns) for institutions and accredited (individuals worth over $2,000,000) investors. 

The internet brought changes to financial markets, allowing discount brokers to effectively compete for the trading accounts of retail and institutional investors.   From 1996 to 1998, investment banking generated up to 40 percent of the money Goldman brought in the door. In 2007, Goldman’s best year, that figure was less than 16 percent, while revenue from trading was accounted for 68 percent.  Goldman Sachs, like many other investment banks, began to largely resemble a giant hedge fund. 

Bailout

Some Solutions:

Fractional or shared ownership

Shared ownership first took off with vacation time shares in the 1970’s.  This concept was troubled with high premiums, dubious marketing tactics and a poor selection of properties.  More recently, better solution arrived:  fractional ownership and shared used has proliferated in the form or fractional jet programs, luxury home fractionals, and car sharing programs.   Since jets, luxury vacation homes, and autos are used only a small percentage of the time, share ownership and shared use programs have effectively reduced the capital and debt service demanded by full ownership while requiring little in the way of sacrifice.

In high density metropolitan areas, car sharing companies like Steve Case’s Flex Car, Zip Car and others represent both cost effective and environmentally friendly alternatives to whole ownership.  While these models are being proliferated in the developed word, they represent a solution to hurdles posed in developing nations regarding affordability, congestion, and the environment.

Peer to Peer Production

The prime example of a commons based, peer to peer production model is open source or “free” software.  Free software is produced through the collaborative efforts of interested individuals that benefit through the collective efforts of others.  Commons based peer to peer production stands in sharp contrast to traditional economic production by individuals on behalf of firms or individuals in markets that are directed by price.

This system appears to work best with information industries that utilize the internet.  Companies like Craig’s list and Wikipedia are examples of firms that have harnessed mass collaborations to build their business platform with little requirement of capital while offering services for free.   Here real social wealth is created without Wall Street banks, wealthy individuals, or venture capital.   In these instances, wealth creation is the inverse of many Wall Street trading operations (particularly financial derivatives) that create little or no social wealth while requiring tremendous amounts of capital.

As of 2007, Craigslist operated with a staff of 24 people.  Its sole source of revenue is paid job ads in select cities.   Craigslist has been so effective, Rich Skrenta at Startupboy.com has made a persuasive argument that Craigslist is worth more than Ebay.  This is debatable.  But regardless of the capital value of Craigslist, because its services are largely free, the social value, something not measure by capital markets, is worth much more than its traditional competitor firms.

Wikipedia is written collaboratively as an online encyclopedia created by volunteers from all around the world.  Since its creation in 2001, Wikipedia has grown rapidly into one of the largest reference Web sites, attracting at least 684 million visitors yearly by 2008. There are more than 75,000 active contributors working on more than 10,000,000 articles in more than 250 languages.

Group Buying

"On an otherwise quiet Friday afternoon in Guangzhou, a city in southern China, 500 shoppers gather outside a Gome electrical superstore in the downtown district. They arrive en masse at the designated time—June 16th at 4pm—that they had previously agreed online. Several hours later, they emerge clutching boxes, having secured 10-30% discounts on cameras, DVD players and flat-screen televisions."

When considering the prospects of doing the same here in the United Sates, one cynical commentator on the web had this to say (offering perhaps a hint to the current status of free-markets today).

“If you got a couple hundred people to go down to your local Best Buy, they’d probably call the cops. Even if they didn’t, the iron-fisted corporate policies of most retailers would probably preclude getting any kind of deal.”

Recently, an important milestone was achieved, validating this business model.  It was the group purchase of an English Soccer team, via the internet.   MyFootball.com created a unique website community by joining over 30,000 members living in 130 different countries, all of whom get to vote on key decisions, from team selection to financial budgets. 

In 10 days, MyFootballClub.com was able to collect 500,000 pounds from 12,000 members.  Soon, they were approached by nine teams that wanted to sell to them.  On November 13, a deal was reached with Ebbsfleet United.  The new owners voted to freeze ticket prices and enjoyed record sales for the 2008/09 season. 

This purchase provides us inspiration, modeling and a major success story, setting the stage for a new generation of higher dollar assets that may be bought, owned and controlled by groups that have traditionally been unable to participate in the direct ownership of large, significant assets.

With the recent implosion of U.S. based bank, car, and insurance companies, one wonders if the credit union model (cooperative) for banks might prove to be a superior to the competitive commercial banking model.

Could Ford or GM prosper as consumer owned cooperatives?  Certain the product mix desired by these companies have resisted efforts to build fuel efficient reasonably sized vehicles.   Planned and stylistic obsolescence have defined the tendency to manufacture waste as growth, leading to environmental and geopolitical problems that have accumulated through the years.  In the early 1960’s, Vance Packard masterfully captured this phenomena in his landmark work, The Waste Makers.  Packard’s book remains as relevant today as when it was written.

Current market values and balance sheet issues for both GM and Ford will soon require “statist” intervention, forcing U.S taxpayers to invest.  As an alternative, a massive auction to consumers might be facilitated to purchase these troubled assets.  After the purchase, the production of these firms might be redirected toward more productive purposes, focusing on improved fuel consumption, alternative fuels, lower emissions, and safety.

Stocks could remain public shares, but as the control of the company were dispersed to a much larger body, the product line of the company might constructively morph into products that conferred larger social benefits than the current Wall Street “maximize shareholder value,” and sky is the limit executive pay mentality.   Creating an employee ownership system with real power (a seat on the board) would also reduce antagonistic relations between factor floor workers and management.  

Reciprocal Exchange

Time Banking