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'The Physics of Wall Street': The Most Arrogant Book in the World? Part 6

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Derivative fact.

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Editor's note: The following column is the sixth part of an ongoing series of articles by Aaron Brown examining the claims made in The Physics of Wall Street: A Brief History of Predicting the Unpredictable, a new book by James Owen Weatherall.

Click here to read Part 1.
Click here to read Part 2.
Click here to read Part 3.
Click here to read Part 4.

Click here to read Part 5.

James Weatherall's recent book, The Physics of Wall Street is the jumping off point for this series. I'm using the errors in the book to explain the difference between finance and what an inexperienced physicist imagines finance to be.

As discussed last week, Weatherall's account of farmers and end users of commodities hedging price risk with derivatives is silly. Forget about a farmer making a deal with a crop buyer. To understand derivatives consider instead the sort of transactions people actually did.

Futures exchanges were set up not by farmers or commodity consumers, but by people who processed commodities and financed the businesses. A canonical transaction is a 19th century miller first going to a grain silo to contract for regular deliveries of exactly the type of grain he needs for his business, delivered when and where he wants it. This is important because efficient operation of 19th century technology required steady running of equipment.

Next the miller goes to the futures market an signs a contract to deliver (yes, even though he is a buyer of physical commodities, he sells them in the futures market, which under Weatherall's assumptions would seem to double his price risk rather than hedge it) a standardized amount and type of grain to a standardized location in a standardized time window. Net, the miller has borrowed grain: he has agreed with the silo to get grain now, and with a financial counterparty to deliver grain in the future.

The miller could instead borrow money and use that to buy grain. This is the basis of credit money. Banks loan money to businesses, the businesses either leave the money in bank accounts or spend it, in which case the recipients either put it in a bank or spend it, either way it remains in the banking system. The loan causes the amount of money to increase, which stimulates real economic activity. The key idea is the banking system creates the capital necessary to build a business, simultaneously creating the currency that will be used to facilitate the transactions necessary for its creation and ongoing operation. It is the economic equivalent of a perpetual motion machine.

There are two basic problems that can occur in this system. First is if banks price loans improperly, that is if they charge the wrong interest rates or approve the wrong loans, there will be too much or too little economic activity, and the wrong economic activity, leading to either recession or inflation followed by collapse. Second is if too many people do not repay their loans, the banks fail, inflicting widespread economic damage, not just from the destruction of capital but from the simultaneous contraction of money supply. Macroeconomists make this stuff really complicated, also the government has legislated a system far more complex and fragile than it has to be. I'm just giving the practical engineer's view, the stuff you need to know to build or fix a financial system.

Direct borrowing and lending of commodities eliminates the need for intermediation by money, which eliminates concern by both parties about instabilities in the value or availability of money. In places where the money and banking system is either undeveloped or troubled, direct commodity transactions become more appealing. In the specific example, if the miller does not have excess capital or good credit, or perhaps cannot prove his creditworthiness, a credit-based system is impractical.

It's worth taking a look at the person on the other side of the miller's futures transaction, the people who are going long grain futures. We already said that it's not the farmer, although in principle the farmer could use it to lend grain-supplying physical grain to the market today and being promised grain delivered in the future. It's more likely someone doing a transaction with two virtual legs rather than one physical and one virtual. For example, someone might go long grain futures for delivery in Chicago and short grain futures for delivery in St. Louis. She has just either borrowed transportation services from St. Louis to Chicago, or lent transportation services from Chicago to St. Louis. Other market intermediaries are borrowing and lending other services using pairs of futures contracts, such as storage (go long the near delivery month and short a delivery month farther out) or cleaning (go long one grade and short another grade).

But it's also possible the miller's counterparty will be a pure financial investor. This person plays the part of a bank lender in a credit-based financial system. He goes long futures contracts and rolls them when they come due. This gives him the economic exposure of someone who owns grain, but he lets real physical businesses use the real physical grain he economically owns. He provides capital, which allows the real physical businesses to operate with less capital. Of course, he expects to earn a profit on his investment. Legally he is labeled a "speculator," but in fact he is as much a lender as any bank or bondholder.

To use direct borrowing and lending of commodities as a financial system, we have to address three issues. First is the problem of credit. If there were plenty of people with good credit and tools for assessing and monitoring credit, we'd probably have a banking system instead. So one step in the transformation of a fixed-price contract into a derivative is elimination of credit risk. This is done by requiring both parties to make daily mark-to-market payments. If you agree to sell me a bushel of wheat in a month for $1.00, and the price of wheat goes up a nickel, you pay me a nickel today and we rewrite the contract to require you to sell me a bushel of wheat in a month for $1.05. The economic effect is the same, I pay $1.05, but I have your nickel, so my net price is the $1.00 we agreed. Now I don't care if you fail to hold up your end of the bargain because $1.05 is the market price of grain and I can buy it from anyone. I am only at risk for one day's price movement in grain, and we both post initial margin payments that are supposed to be enough to cover any one-day move. If you fail to make any daily mark-to-market payment, I get paid instead out of your initial margin, and the contract is terminated (which doesn't matter because it is now written at the market price).

Sharp-eyed readers will notice that we have replaced credit risk with liquidity risk. The derivative financial system above assumes there is an agreed price of grain every day, and that we can set a reasonable limit on the size of daily price movements. This is why in the 2007-09 financial crisis central banks found their traditional role of lender of the last resort was ineffective, instead they had to become dealer of the last resort. Central bankers didn't have to lend money to insolvent financial institutions, they had to buy and sell securities to establish liquid prices so the mark-to-market system could function. Today we are in a derivative economy in which liquidity, not credit, is the most fundamental requirement.

Next week we'll look at what it means to have a liquidity-based financial system.
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