The Derivatives Market Is Not a Capital Market

Derivatives get a fair amount of criticism. They are largely blamed for the financial meltdown. Warren Buffett called them "financial weapons of mass destruction." I must also toss in my criticisms. The derivatives market is not capitalism but a casino for speculators.

When you buy a stock, you are providing capital to a business. The business uses this capital to build its business and make a return to you, the investor. Now, this is usually at the initial stage of the venture when there is an IPO. After that, the capital is sunk. The stock market enables investors to move their capital at will to other places. It allows the business to keep the capital invested in the enterprise. This is a good thing.

When you buy a bond, you are also providing capital to a business. You are lending money at interest. The business pays back the money with interest. They use this loan to build the business and keep it operating. This is also a good thing. The stock and bond markets are what build America. Traditional investment banking the way Goldman Sachs used to do it is truly God's work.

There are speculators in the bond and stock markets. These people are not investors. They are out to make a quick buck. They have holding periods as little as a second. This may seem bad, but it isn't. Speculators provide liquidity. This is why there is always a buyer when you want to sell a stock, and there is always a seller when you want to buy a stock. Speculators may do damage to their own fortunes, but they do not hurt the market. This is a good thing.

Derivatives are different. They do not provide capital to a business in any way. The best thing they can do is hedge against the loss of capital. A farmer can buy a futures contract on his wheat and lock in a price that ensures his profitability. An investor can buy an option to reduce the risk on his stock holding. Derivatives act as an insurance policy against capital loss. This is a good thing.

Derivatives become a bad thing when you realize that many of the traders in this area don't own the underlying assets which give the "derivative" its name. The value of the derivative is based upon the future value of some asset. It is essentially a bet not unlike betting on horses, football teams, or a hand in blackjack. Some will argue that buying a stock is also a bet. But there is a key difference. A stock provides capital for a business. A derivative does not. Naturally, the derivatives market dwarves the stock market by a ratio of 3 to 1. Needless to say, the big money is in trading derivatives. This is a bad thing.

Because the derivatives market is not a capital market but a casino, it becomes a zero sum game. Contrast this to the stock and bond markets which are positive sum games. Investors provide capital which businesses need. Businesses use capital and accumulate more capital. Everyone is better off on the whole. Sometimes, there is a loss of capital due to bad investment or whatnot. The result is that the capital will flow to where it will be best utilized. This is why 90% or more of businesses in the stock market have failed, but the market and America have seen consistent growth and return.

In the zero sum game of the derivatives market, wealth is not created. It is merely shifted around from one person to the next much like a poker game. For every winner, there must be a loser. This is why the recent meltdown produced big losers but also stories of instant billionaires who were on the other side of the bet. This is no big deal since only the fools who choose to play the game are hurt. Unfortunately, many of those fools are able to turn to the government to bail them out which hurts me and you because they take our capital to pay down their losses at the casino and give them a fresh pot to gamble with. In the case of some like Goldman Sachs, you get your money back with interest. In the case of others, you don't get shit back. But either way, the country as a whole is exposed to risk it is not being compensated for taking. Perhaps there should be derivatives on future tax increases.

The country was never in danger of financial collapse. It was the gamblers that were in danger of losses. They are still in danger. This is the way it is with the derivatives market. This is not God's work. This is the Devil's work which is the primary business of Goldman Sachs these days. Investment banking is just a ho-hum business compared to the red hot trading desk. But thanks to the government, the derivatives market now has the power to destroy real capital.

Casinos do not create wealth. They provide excitement and entertainment. On the whole, gamblers will leave poorer instead of richer. This is the essence of the zero sum game. The derivatives market is no different than this casino except that the cleverest quant finds himself being the casino owner. This is the goal of the derivatives trader. It is to figure out the stats and buy accordingly in order to be the casino owner who never loses as a consequence of the law of large numbers. This can get very complex.

The stock and bond markets are stone simple. The easiest way to be the casino owner there is to buy the indexes. No such strategy exists for the derivatives market. This is because of the zero sum game. The derivatives market only grows proportionally to the number of suckers in it. It is a sure bet that it will get bigger.

The derivatives market of today is merely a modern and more respectable version of the bucket shops that used to exist back in the day. Bucket shops were betting parlors usually in storefronts where retail investors would buy stock except the bucket shop operator did not buy the stocks but pocketed the money. He would pay the difference if the stock went up or collect the difference when the stock went down. It was considered a shady business and was outlawed. The derivatives market is the new bucket shop except that it doesn't cater to retail investors anymore.

So, do derivatives have any legitimacy to capital markets? They do act as a hedge against risk which can be useful in preserving capital. But the problem with this is obvious. Those derivatives are worthless if the person who assumed the risk is unable to pay. It is like buying insurance from a bankrupt insurer. This is not insurance at all but a fiction. With the inability to pay, derivatives are useless to capitalists.

What should the government do about all of this? The most basic thing it can do is stop being the insurer for this market through the Fed and Goldman Sachs and whoever else they can bail out. But regulating it is a waste of time. The last 80 years of government regulation of the markets should show that it does nothing to stop this sort of thing. What does make it bad is providing cash and cover for these idiots which is precisely what the government is doing.

Posted in: