Why Things Are Going to Get Worse - And Why We Should Be Glad. Michael Roscoe
to stay competitive – hardly applies to investment banking, where one trader can make millions simply by pressing a few keys on his keyboard, just as long as his luck doesn’t run out.
But it is exactly this lack of real jobs and industry that makes the growth of the financial sector so damaging to the real economy. When banks made most of their money by lending to industry for investment in new wealth-creating business, or by lending to the middle classes so they could buy homes and cars, they had a direct link to the real world. It was in bank managers’ interest to make sure their customers prospered.
All that changed during the 1980s and 1990s. Thanks to new legislation forced through by the influential executives of Wall Street and the City, many of whom had close links to government in both the US and UK, liabilities became limited. Commercial banks began to indulge in practices that had previously been limited to investment banks, resulting in a new bonus culture in which managers and traders got rich using other people’s money. Combined with new technology that made international trading and speculation much easier, this led to a rapid rise in what has come to be known as ‘shadow banking’.
Figure 30
As wealth accumulated and more of the banks’ profits came from speculation, bankers began to lose their traditional link with the real economy. They were amassing more money than was needed for real investment, and they began to devise increasingly unorthodox methods of using that money to create more money. The big banks also began to acquire stakes in other companies on a scale never seen before, to the point where, according to a 2011 report by the Swiss Federal Institute of Technology, a small network of the biggest transnational banks and other mostly financial institutions – what the researchers called a ‘super-entity’ of 147 closely linked companies – controlled 40% of the global economy in terms of revenue.
This trend towards massive wealth accumulation in a select group of transnational banks (which really means a relatively small group of influential owners, executives and investors) has distanced the banks from their traditional high-street banking activity – real investment on the ground, as it were – and focused their attention on making much bigger profits through share dealing and speculation, a trend that can be seen in the growth of the derivatives market.
Figure 31
A derivative is a type of contract between two parties, the value of which is ‘derived’ from an underlying asset; it has no value in itself. The contract specifies a future date at which an agreed transaction will take place, but the nature of that transaction varies, depending on the type of contract.
The most common are ‘Forwards’ or ‘Futures’, where one party agrees to buy an asset, and the other to sell it, at a future date, but at a price specified at the time the contact is made. Another type is an ‘Option’, which means the buyer has the right, but is not obliged, to buy the asset at the agreed price.
The asset in question can be anything that is traded, but the most popular these days are currencies, equities and commodities. Interest-rate and exchange-rate contracts make up the bulk of derivative trading, which means that a huge chunk of financial activity consists of betting on the future strengths of currencies relative to each other. As Figure 32 shows, the derivatives business grew rapidly, to the point where the notional values being traded far exceeded the underlying asset values (and also far exceeded the US regulated limit, which American banks got round by operating from their London offices).
This recent explosive growth in the trading of various complex forms of securities stemmed from the technological revolution that brought us the internet, without which such huge volumes of information ‘sifting’ would be impossible. The general idea is to profit from the change in price of whatever it is one is dealing in, either over time, as with futures, or almost instantly, as with the process of arbitrage – taking advantage of the temporary price difference between different markets. To the traders sitting at their computer terminals, it can seem like an exciting game, not so different from online gambling.
One such derivative ‘instrument’, to use the trade jargon, is the Credit Default Swap (CDS), a form of default insurance on bonds issued by corporations or governments. Most of the $30-trillion annual trade in these CDS contracts is undertaken by speculators who have no interest in the underlying protection, but merely want to profit from buying and selling contracts as the prices shift according to the perceived risk. Such purely speculative CDS dealing is termed ‘naked’ trading.
Figure 32
The traders typically make large bets against a government or corporation meeting its payment obligations. Naked CDS trading can increase the risk of default by raising borrowing costs, as happened to Greece, for example. The trade lacks regulation and has been much criticized, being implicated in the failure of many large financial institutions, some of which had to be bailed out with taxpayers’ money.
I will leave the moral judgment on such naked speculation to others, but one thing I feel reasonably sure about: there is no real economic value to any of this activity, and certainly no real wealth creation involved.
Futures past
Derivatives evolved in the 18th century as contracts to buy a particular agricultural product, such as wheat or rice, at a future date, at a price agreed in advance. The point was to protect the buyer, usually a merchant, against the risk of rising prices caused by crop shortages. The seller, usually a farmer, agreed the price because he had a guaranteed market and, all being well, would make a good profit. Futures contracts thus served a useful purpose for traders and producers alike, by reducing the uncertainty over products whose future quantity, and therefore price, could not be reliably predicted.
These days the transaction can either be through an exchange, such as the Chicago Mercantile Exchange, or ‘over the counter’, meaning the two parties negotiate directly with each other. The latter is more commonly used, as it is free from regulation. It is these over-the-counter derivatives that have been the biggest source of bank failures in recent decades, the failure often being blamed on a ‘rogue trader’ (effectively an online gambler who got a bit carried away, and whose luck ran out).
Figure 33
In 2011 the Bank for International Settlements announced that the total amount of over-the-counter derivatives outstanding had reached a new record of $707 trillion (which looks like this, by the way: $707,000,000,000,000), which was more than 10 times total world GDP (around $63 trillion in 2011 – see Figure 33).
One reason these sums are so huge is that they represent commodities or currencies that will never actually change hands, and can be traded any number of times by different traders at the same time – hence the absurdly high ‘notional’ value. Also they include two-way bets. The trader isn’t actually at risk of being asked to pay the full amount gambled because if one bet loses the other must win; the bets are ‘hedged’.
So a notional value of $700 trillion represents a gross market value of around $25 trillion, which is what the contracts would be worth if they had to be settled on the day. Taking out the bets that offset each other, this gross value is reduced to an actual value more like $6 trillion. This compares with $18 trillion of global merchandise trade (in 2011). So the actual value of the derivatives trade is around a third of the trade in real goods, even though derivatives have no real value in themselves. This ratio of one-third phantom wealth in the financial sector relative to real wealth in the economy appears to have some significance, as we will discover later in