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AN ECONOMIC WONDERLAND: DERIVATIVE CASTLES BUILT ON SAND

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Headlined to H4 12/20/09

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Accompanied by massive and sustained pressure towards the deregulation of all markets and stock exchanges in particular, what had been originally created as relatively crude instruments for hedging loan exposure developed rapidly into far more sophisticated instruments to feed the voracious demand for capital fuelling the non-inflationary continuous expansion (NICE) era of the 1990s. By the turn of the century credit derivatives had multiplied so rapidly in type and extent and capital capture that they constituted a market of themselves, and the fall of Enron and what that had to say about the risk associated with credit derivatives was effectively dismissed by markets, institutions, academics and professionals alike. As an editorial piece in Risk magazine implied, shortly after the fall of Enron:

"Credit derivatives proved to be resilient [. . .]. The episode, and the fact that the exercise of the Enron credit default swap contracts was done in an orderly manner without controversy, showed that the market had come of age."

Derivatives had been weighed in the balance and not found wanting; added to which of course the amounts of capital now invested in them plus the maturity of what had become a market of central importance meant that, barring a disaster like the current one, they could not be allowed to be perceived as having failed, as having an essential flaw.

This "coming of age" of the market was accompanied by an acceleration of the amount of money invested in this market. As we now know, whereas banks in particular were important participants in this market from the beginning, hedge funds became increasingly involved as they too became important players in global capital markets. Financial derivatives became somehow synonymous with the buzzword "globalisation" exotic, powerful and barely understood even by the most unquestioning fans. So representative had they become as part of the market fantasist discourse that they were accepted almost universally (with a few notable exceptions such as George Soros and Warren Buffett) as what they have become fatal to the securitisation of risk. Derivatives were institutionally accepted as a marker of good health to the extent that (with exceptional irony) by 2004 the credit default swap (CDS) market was accepted as an accurate measure of credit quality.

What had also become clear, however, was that no one state had the capacity to understand, much less supervise, the CDS market, whether it be through the more formal regulatory approach of the USA or the "light hand", self-regulatory approach of the UK proprietors, respectively, of the most important financial centres in the world, i.e. the New York and London stock exchanges. In the market fantasist view, however, not only was this not seen as a disadvantage but, given the apparently "perfect" functioning of derivative markets this was one more proof of the superiority of market over state and over state-channelled democratic oversight the markets were themselves become democracy in action.

At the same time that the international financial institutions (World Bank, IMF etc.) were demanding more transparency, openness and accountability from the governments of countries in development, the globalising financial services sector was lauding the development of markets of increasing obscurity and impenetrability, over which regulation and oversight were all but impossible. The full scale and surreal nature of this market and its critical importance become apparent only when one looks at Bank of International Settlements estimates for the total monitored trade in derivatives some $680,290,700,000,000 for 2007-2008.

Continuing faith in market fundamentalism, however, means that in all of the current talk of "bail-outs" and "rescue packages" the concentration of governments around the world has been overwhelmingly on easing the short-term liquidity crisis, which is to say examining the symptoms of the illness whilst doing little to examine the long-term causes. It might (for instance) be thought that the massive state intervention which the crisis has occasioned, the nationalisation of banks and the loans of taxpayers' money to failing institutions should be accompanied by task forces not only to investigate the exposure of each and every recipient of public money to the "toxic" instruments, but in working out how to defuse the global market in derivatives, how to regulate such instruments effectively and how to licence very strictly their future development. Despite lip-service being paid to regulation of these kinds, the emphasis is strongly on bail-outs and interest rate cuts "recapitalisation" is the order of the day. The bankruptcy of this particular way of thinking, however, is obvious in phenomena such as the gap between the LIBOR inter-bank lending rate and central bank interest rates banks know very well what they've been up to and they also now know that they can't trust the value of their assets.

They f * * * you up your markets do, but they were built to, just by you . . .

"So combine an opaque and unregulated global financial system where moderate levels of leverage by individual investors pile up into leverage ratios of 100 plus; and add to this toxic mix investments in the most uncertain, obscure, misrated, mispriced, complex, esoteric credit derivatives (CDOs of CDOs of CDOs and the entire other alphabet of credit instruments) that no investor can properly price; then you have created a financial monster that eventually leads to uncertainty, panic, market seizure, liquidity crunch, credit crunch, systemic risk and economic hard landing (Roubini, 2007)".

Market fundamentalism purports to be a moral analysis of human activity, and as a consequence of the necessity to justify the functioning of capitalism, a variety of ethical arguments are attached to both markets and capitalism:

"Capitalism is the only system that fully allows and encourages the virtues necessary for human life. It is the only system that safeguards the freedom of the independent mind and recognizes the sanctity of the individual (Tracinski, 2002)."

The signalling of virtuous market functioning is transmitted by price structures decided on through the use of relevant information and the analysis of risk, with the concomitant effect that this has on changes in market prices over time. The precept of risk is another fundamental pillar in the moral basis of market fundamentalism, the idea that an entrepreneur undertakes to risk capital through analysing the market for a product, setting the price through use of available information on both market and product, and accepting the risk of losing capital that failure to get your calculations right may bring it is not an exaggeration to say that the taking of virtuous risk by the entrepreneur justifies by itself the profit-making underlying capitalism in this reading.

However, the entire purpose of many derivatives (and the CDS in particular) has been to separate risk from product. Risk analysis, the commodification of and the trade in risk are specifically designed to factor out this virtuous uncertainty that justifies profit:

"They mass manufacture moral hazard. They remove the only immutable incentive to succeed

market discipline and business failure. They undermine the very fundaments of capitalism:

prices as signals, transmission channels, risk and reward, opportunity cost (Vaknin, 2005)."

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http://www.lboro.ac.uk/departments/gy/research/res_gawc.html

Jon Cloke is a research associate with the Globalization and World Cities Network and also Project Officer for an alternative energy network, EnergyCentral, devoted to the promotion of alternative energy links between and within Europe and Central (more...)
 
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