All about derivatives

With the financial crisis crashing the world down around our ears you get to hear a lot of technical terms for things that may or may not have lead to the collapse. One of those terms is “derivatives”.

Here is the best description of stock market derivatives and their role as a source ofinancial evil. This from a chinese communist, no less;

If you look at every one of these [derivative] products, they make sense. But in aggregate, they are bullshit. They are crap. They serve to cheat people.

I was predicting this many years ago. In 1999 or 2000, I gave a talk to the State Council [China's main ruling body], with Premier Zhu Rongji. They wanted me to explain about capital markets and how they worked. These were all ministers and mostly not from a financial background. So I wondered, How do I explain derivatives?, and I used the model of mirrors.

First of all, you have this book to sell. [He picks up a leather-bound book.] This is worth something, because of all the labor and so on you put in it. But then someone says, “I don’t have to sell the book itself! I have a mirror, and I can sell the mirror image of the book!” Okay. That’s a stock certificate. And then someone else says, “I have another mirror-I can sell a mirror image of that mirror.” Derivatives. That’s fine too, for a while. Then you have 10,000 mirrors, and the image is almost perfect. People start to believe that these mirrors are almost the real thing. But at some point, the image is interrupted. And all the rest will go.

When I told the State Council about the mirrors, they all started laughing. “How can you sell a mirror image! Won’t there be distortion?” But this is what happened with the American economy, and it will be a long and painful process to come down.

I think we should do an overhaul and say, “Let’s get rid of 90 percent of the derivatives.” Of course, that’s going to be very unpopular, because many people will lose jobs.

The rest of his article is brilliant and serves as a reminder to all about the perils of over-reaching.

  • itsatrap

    That’s a nice analogy.

    However the Chinese government has been one of the largest purchasers of US Treasury Bonds in the last few years, so they must have had some confidence in the strength of the US economy.

91%