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'The Physics of Wall Street': The Most Arrogant Book in the World? Part 8

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Derivative importance.

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Editor's note: The following column is the seventh 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.
Click here to read Part 6.
Click here to read Part 7.

In this series, I'm using the errors in James Weatherall's recent book, The Physics of Wall Street to organize an overview of modern finance.

Last week we described how organized trading of fixed-price contracts for future delivery could lead to a liquidity-based form of money. Before discussing why that matters, we need to mention two more steps needed to transform fixed-price contracts into derivatives. They are both things to improve liquidity. First is standardized contracts. If everyone borrowed or lent exactly what they needed, there would be too many prices to keep track of, and no chance that all of them would result in liquid markets. With futures, a basic set of standardized market factors are traded, which can be combined to represent many future goods or services. If you want to lend transportation services in the future, go long a commodity in one location and short the same commodity in another. If you want to borrow cleaning services, go long one grade of commodity and short another. Since physical delivery is not the point (contrary to Weatherall's fairy tale) people are willing to enter into futures contracts whose settlement prices are correlated to the things they want to borrow or lend, they do not need the exact items.

Finally, you cannot have a liquid market with bilateral contracts between specific buyers and sellers, because two contracts would not be interchangeable. Instead, rather than you agreeing to sell me a bushel of wheat for $1.00, you agree to sell to a clearinghouse, and I agree to buy from the clearinghouse. The clearinghouse holds our margin payments, and never has net positions. What this means is if I later want to get out of the contract, I don't have to find you, I just find anyone else willing to agree to buy the bushel of wheat. She and I go to the clearinghouse, and execute our offsetting contracts. I now have identical contracts, one to buy and one to sell, both with the clearinghouse, so I can tear them up.

As mentioned above, physical delivery is not the point of derivatives, mark-to-market payments are. The miller in last week's example will never deliver wheat into his futures contract; when each contract delivery comes up he will "roll" it into a future delivery month (that is, if he has a January contract to sell wheat, in January he will enter into a January contract to buy wheat, offsetting his existing contract, and also enter into an April contract to sell wheat). This is the same as a business that takes out a money loan, when that loan comes due the business will take out a new loan to repay it. It's not the principal that matters, it's the interest payments. Only when businesses change or liquidate are the derivative positions shut down and the loans repaid.

Now we can see why derivatives are so revolutionary. It's not the ancient notion of a fixed-price contract, it's the active exchange, the standardization and the clearinghouse that create a new form of money. That's what happened in 19th century in the Mississippi River system, and again in the 1960s and '70s all over the world. This is what makes derivatives something modern, not a 4,000-year-old concept.

Derivatives stimulate the economy by financing businesses and facilitating transactions, just like a banking system. We can also see why financial engineers worked so hard from around 1965 to 1980 to replace national-government-issued credit-backed money linked to gold with derivative money designed after the model of futures exchanges. Milton Friedman lobbied President Nixon to take the world off the gold standard, Merton Miller worked hard to get approval for trading of futures and options on financial underlyings, many other people worked to get approval of financial institutions outside the regulated banking system to take deposits (money market funds), make loans (mortgage lenders who securitized their product rather than lending deposits from the public) and invest money (public mutual index funds instead of broker-managed accounts).

Beginning in the 1980s, another important change was redefinition of bank capital. Credit-based bank capital is equity contributed by founders or earned as profit. It serves to cushion credit losses. If a borrower does not repay the bank, bank capital can absorb the loss so depositors are not harmed. But a derivatives-based economy defines capital in a risk-based manner, the ability to cover daily price changes in a bank's assets and liabilities. Instead of waiting for actual defaults of a bank's loans and seeing if it has enough capital to cover them, a bank should set aside capital every day for changes in the probability of future defaults. In theory, when a bank is unable to do this while maintaining a suitable level of initial margin, it goes out of business, but there is no loss to anyone because at that point its assets are greater in value than its liabilities.

Of course, there is many a slip 'twixt the cup and the lip. Things did not work out exactly as predicted, for reasons I will discuss later. But the basic idea in the Basel capital accords is that bank capital requirements are defined by models predicting the extreme short-term movements in the net value of a bank's portfolio. The rules are extremely complicated and do not always correspond to financial theory, but the general direction is liquidity-based, not credit-based.

This new definition of bank capital allowed the creation of a new kind of derivative, one that dispensed with clearinghouses and standardization; and in its early evolution with initial margin and frequent mark-to-market as well. These are "over the counter" (OTC) derivatives, as opposed to the "exchange traded" ones described above. It may seem as if OTC contracts have lost the three defining characteristics of a derivative. That was true initially; people relied on AAA credit rather than liquidity, which allowed expansion of derivatives into much less liquid markets than had been possible earlier. But people gradually engineered virtual substitutes for the physical trading floors, clearinghouses and margin payments. We saw the same sort of thing earlier with coins, as coins made from precious metal equal to their full value were replaced by more and more debased coins and finally tokens of symbolic value only; and credit-backed paper money was replaced by government-issued notes with no explicit backing by loans or explicit promise to exchange for precious metal.

Next week we'll see how derivatives work in the modern economy.
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No positions in stocks mentioned.
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