There's been a lot of talk over the last several year about derivatives and the role they play in our financial system. Warren Buffet once referred to them as weapons of mass financial destruction. A recent New York times article, focused on the fact that only a hand full of banks are involved with the business and they want to keep out competition by controlling the clearinghouse so that price discovery is limit, keeping their monopoly in place and their profits high. Especially now that revenue for the banks have been falling. Home loans are shrinking along with credit cards as the consumers deleverage. Transaction fee are also down along with typical banking charges, for bounced checks and over drafts.
Derivatives function much like an insurance policy allowing business, pension funds and local government's to hedge risks. An airline for instance may purchase a derivative to hedge against rising fuel costs or a municipality may buy one to protect against rising interest charges on it's debt. The problem is two fold. First the cost of this insurance is factored directly in to fees consumers/taxpayers end up paying. Your airline ticket may be higher or your gas bill may increase as the companies buy derivatives to hedge themselves. All the risk associated with doing business is being shifted to the consumer. You mainly see derivatives associated with the essentials you need like food and fuel because you have to buy them (inelastic demands) and it affords the banks(derivative broker) the highest profit. This in itself seems unfair to consumers, but it gets worse.
Problem number two, if cost didn't change very much then the need for such insurance policies like derivatives would go down, generally a good thing, but here's were it gets sticky. The government regulates the futures and options market with a agency known as the CFTC, Commodity Futures Trading Commission. There job is to oversee the market place and make sure it is open and honest. For years the hedging of commodities has been done with futures contracts and options, with the stipulation that in order to use these instruments you needed to be directly involved with the production or distribution of the commodities. Changes to the laws in the Clinton years, had a profound impact on these markets. They allowed institution such as banks, hedge and pension funds as well as speculators to enter these markets. This hot cash looking for profits causes a huge increases in volatility. Which drives derivative prices up even further to protect against the volatility. These entities have huge amounts of cash and in the place of banks, the have access to the FED and unlimited cash at below market rates. If the Banks are on the other side of a derivative they could easily drive the price in their favor or at least increase the volatility causing the premium paid to increase. This conflict of interest is dangerous, but there is more. To in sure fair markets the CFTC imposes position limits on futures and commodities, this prevents a large player from manipulating the price. The only problem is that the CFTC has ignored these limits. Especially in the precious metals and perhaps the oil market. This allows large groups to control the Futures and option markets, making a killing and in the case of banks charge huge premiums and maybe even work against those who bought the derivative contract from them in the beginning. No one actually knows because this entire industry has so little transparency.
So in effect we have a derivatives market designed to hedge against the futures and options markets which hedge against the unforeseen episodes of everyday life, like weather, economic fluctuations and other uncertainties. With both systems adding the profits of the middle men and the risk associated with doing business to the consumer. It's like the mafia selling protection to small business from sudden accidents like firers and union shut downs. The very disaster your being insured against is in the hands of your insurance agent. Nice gig if your the insurance provider or this case the derivative provider ie the banks.
So, in the very professional and business like setting of bank board rooms a blossoming business straight out of the Godfather has developed and just like when these scams were run by the mafia in it's hay day with local politicians on the take, we have the DC politicians and their campaign contributions moving in to take their place.
In part two we'll take a look at the reason our government most like will not change this market and it's effect on the economy
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