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The Virtual World of Derivatives: The Art of Gaming the U.S. Financial System
The Evolution and Growth of Immaterial ExchangeAs 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 ....
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.
In 2007, the average income for the top ten hedge fund managers was $1.6 billion. A year later, as a result of bets made that could not be covered (primarily resulting from the credit default swap market) the United States banking system was effectively insolvent.
In less than one month, following the bailout of government sponsored entities Fannie and Freddie, the worlds largest insurer (AIG), and the United States fourth largest investment bank (Lehman), went under. Within days, a short sale ban was instituted and a $700 billion bailout plan was hastily announced in order to stave off a systemic collapse.
Merrill Lynch was bought by Bank of America in a shotgun marriage while Goldman Sachs and Morgan Stanley were converted to commercial banks in order to give them access to the Fed's lending facility. The Wall Street investment banking era was effectively over.
Like a game of high stakes poker, a virtual economy had been created with no reference to material production. Value was too often created without real money and real risk trading hands. As in any game, the system breaks down when the shared rules of the system no longer function.
Like NASDAQ stocks, house values, and oil, the value of mortgage back securities became divorced from the real asset values of the homes in which they were referentially attached. House values that were tolerated as prices were pushed above affordability for average wage earners, were now unacceptable. As the value of mortgage debt dropped beneath the asset values of the actual homes in which they are tied, major bank balance sheets suffered losses that pushed them to insolvency.
Bailout
On Friday, October 5th, 2008, Henry Paulson's $700 billion bailout plan was approved, effectively socializing losses earned on unprecedented returns on investment, based largely on leveraging bets as high as 30 to 1. The systemic collapse of the unwinding of leverage created a panic with a political response requiring largely illiquid wager earners to bailout those with money at stake in the game.Now the value of real labor that has value because it produces actual things is asked to cover the bets made by those that produce nothing. This is bizarre and unprecedented as socialist principals have been inverted, creating a political form more closely resembling Fascist corporatism, plutocracy or even kleptocracy.
Whatever the case, a choice has been made and it is to be imposed upon an frightened and impotent taxpayer.
A more reasonable solution would be a repatriation of profits made from trading this toxic financial instruments. This way those that benefited may collectively cover their own bets. It is interesting that while an estimated $600 billion had been made by hedge funds in recent years, very close to the amount asked for by the government of its people. It is also worth noting that many of these profits were made from offshore accounts that avoided financial reporting and U.S. taxes. Yet so far none of these funds are being repatriated to cover losses.
Free markets are a system and an ideology. The system itself was compromised long ago while the ideological premises grew more powerful and effective, aided by the compounding of profits and the force of money. It is clear today that the ideology of free market capitalism is lacking a sound critical basis. Analytical models need to be revised in light of the impact of value creation in the sphere of the immaterial. Fashion, art, and gaming provide supplementary models of behavior that help to describe our current economic system.
Classicical and neo-classical economic analysis falls short in accounting for the realities of immaterial exchange. Old texts are in no way the reliable descriptors they have been in the past and are as outdated as the viewpoints of Alan Greenspan, who was wrong on just about everything, from the benefits / risks of adjustable rate mortgages, the impact of historically low interest rates, the existence of the housing bubble, to the dispersion of risks created by mortgage back securities and financial derivatives.
Price discovery is the capitalist system of equilibrium. Must to regress to an earlier state of exchange or find a new principal of equilibrium that more rationally determines value in view of meaningful outcomes that lie in the real world, not the virtual?
Or can we resurrect market exchange less dependent on debt finance and capital?
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.
Both Wikipedia and Craigslist have displaced traditional profit based business and provide a model of production that effectively taps the collaboration of individuals around the world.Group Buying
Group buying consists of like-minded individuals that join forces using a number of strategies to securediscounts that might not otherwise achieved on their own. Group buying is similar to a cooperative, where informal groups organize and buy directly from a wholesaler. In the United States, a number of high profile start-ups tried and failed at this concept, focusing on low margin goods bought by online retailers. Outside the U.S., group buying has nonetheless continued and prospered. In China, a form of group buying called Tuanguo, focuses offline at retail stores. In September of 2006, an Economist article reported:"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 share property exchanges were first generation examples of reciprocal exchange networks where property owner's barter goods using points and not money. Prior to the internet, most of these were run by large firms with significant capital requirements. More recently, small firms have entered this space, providing property swap services to private owners. On the lower end, HomeExchange.com has 24, 000 properties available for swap around the world. At the luxury end of the market, Trade to Travel assembled 1, 200 properties in 32 countries, using a point based banking system that allows for non simultaneous (meaning you don't have to exchange directly with another owner) swaps. Time Banking
Time banking is a form of reciprocal exchange of services that uses time as a currency. It is an example of an alternative economic system that may create and circulate wealth without creating debt or needing capital. The largest time banking system was created by Edgar Cahn, the founder of Time Banks USA, a nonprofit active in 22 countries. Their unit of currency is always reflected as an hour's of worth of any person's labor. While this makes for easy accounting, it blocks the ability to exchange vastly unequal forms of labor. For example, it is likely that raking your neighbor's leaves for an hour does not match well with another person providing professional services that require specialized training and equipment. That said, since services are banked and not exchanged directly, many of these transactions may take place despite the inequality in the market price value of services rendered. Time banking is unique in its creation of wealth outside of the requirement of capital. Conclusion:As dependence on the services of investment banks declined, the need to financially engineer new products and services become greater. The products and services they created became increasingly divorced from the real purposes of banking and move closer to style changes made on finished goods than products manufactured to solve real needs. An artificial market became more a rule than an exception, contributing to a series bubbles - stocks, housing, commodities, and a super bubble in financial derivatives. Bereft of regulation combined with the unlikelihood of prosecution, the market become rigged for the benefit of insiders. As capital is destroyed and confidence in capital markets is eroded, new solutions, some of which are described here, will facilitate the creation of wealth with less dependence on debt and capital. Our need for capital will not disappear, but our dependence upon it is declining.
Contact: James Pruett
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