financial derivatives

Is Your Bank Trading in Financial Derivatives?

Financial derivatives are contracts between two parties whose value is determined by changes in the value of an underlying asset. Those assets could be stocks, bonds, currencies or commodities (such as oil, wheat, precious metals).

Most of these contracts are traded over the counter, where details about pricing and risk measurement are not available to the public.

Although there are many types of derivatives, here’s an example of a basic options contract:

financial derivatives contractBanking Investor Party A enters into a derivative contract with Investor Party B. The Banking Investor Party A bets that the future price of an asset such as gold will be substantially different from the expected price held by Investor Party B. Party A operates under the assumption that Party B has it wrong in regard to the future market price of gold, and Party A looks to profit from Party B’s error.

 

Financial derivatives are essentially bets that something either will or will not happen in the future.  Someone wins. Someone loses. Just like in Vegas, only the bets are far bigger…

Pension funds use derivatives to hedge investments. States and cities use them to hold down borrowing costs. Airlines use them to secure steady fuel prices. Food companies use them to lock in prices of commodities like wheat or beef.

However, only a handful of firms, such as banks and insurance companies, represent the majority of the total derivatives traded in the world. 

According to the Bank of International Settlements, by December 2014, there were $630 TRILLION in world contracts still outstanding in the over-the-counter (OTC) derivatives markets.  That is about 8 times the size of estimated world gross domestic product of $75 trillion. 

Financial Derivatives: Weapons of Mass Destruction?

warren buffet financial derivativesIn 2002, famous investor Warren Buffet called derivatives “financial weapons of mass destruction”. Then, in 2015, he reaffirmed that view saying that they pose a threat to the global economy and financial markets. Buffett did say derivatives can still serve a purpose when used intelligently for some short term contracts. “It’s like the difference between a controlled fire and one that is uncontrolled.”

The mystery of derivatives is widely believed to be at the heart of the financial meltdown in 2008. It wasn’t only reckless lending and excessive risk taking. At the core, it was a lack of transparency.

Yet five years after the crisis, there was even more secrecy. The nation’s 10 largest banks were even larger – with total assets up 28% at the end of June 2013.

The secrecy surrounding derivatives trading is a key factor enabling banks to make such large profits. Using sophisticated computer algorithms, the big banks that do most of the trading in these derivatives do very well a majority of the time.

Banks don’t tell investors how much they could lose in a worst-case scenario, nor are they required to. If anything does go wrong, banks like JP Morgan Chase and HSBC could wreak havoc for many nations because they are connected to so many global banks and investors.

When outside experts can’t assess risk and when large bets go wrong simultaneously, the whole financial system can freeze and lead to a global financial meltdown in much greater proportion than 2008.

Governments used resources to bailout those “too big to fail” banks in 2008. Today’s cash-strapped governments are in no position to cope with another massive bailout.

 

Visualizing Financial Derivatives

The demonocracy.info infographics below show the amount of exposure to financial derivatives in 2013 by JP Morgan Chase Bank and Citibank, the top 2 banks in the U.S. dealing in derivatives.

The 35 tall stacks of pallets of $100 bills next to the JP Morgan Chase Bank building in the background represents its derivative exposure of $70 trillion in 2013. Each tall tower represents $2 trillion.

To understand the enormity of that number, the semi-truck in the lower right hand corner below the bank’s sign is filled with pallets worth $2 billion. Also for comparison are a football and soccer field along with the White House.

JPMorgan Chase Financial Derivatives Exposure

JP Morgan Chase Bank http://Demonocracy.info

 

The 26 tall stacks of pallets of $100 bills next to the Citibank building in the background represents its derivative exposure of $52 trillion in 2013. Each tall tower represents $2 trillion.

To understand the enormity of that number, the semi-truck in the lower right hand corner below the bank’s sign is filled with pallets worth $2 billion. Also for comparison are a football and soccer field along with the White House.

Citibank Financial Derivatives Exposure

Citibank http://Demonocracy.info

 

In addition, the Office of the Comptroller of the Currency provided a list (on page 26 and shown below) of the top 25 banks in 2015 and their derivative activities.

Is your bank on the list?

financial_derivatives_march_2015

Office of the Comptroller of the Currency, March 2015

 

 

I believe the best investment we can make is in our financial education.

Many financial advisors encourage clients to park a small portion of their portfolio in precious metals such as gold outside the banking system as a wealth protection “insurance”.

Let me show you how to set up your private gold savings account.

 

Believe in the best. Prepare for the worst.

Let’s talk.  Was this blog helpful to you? Leave comments below.

good money

 

 

 

 

757-310-9175

jameslawson.ws@gmail.com

6 Comments

  • Kay Somji

    Reply Reply February 15, 2016

    Great article James, I learned a lot from your post about financial derivatives. Thanks for sharing!

    • jameslawson.ws@gmail.com

      Reply Reply February 15, 2016

      Thanks Kay!

  • Roxann

    Reply Reply February 15, 2016

    Thanks James for your information on financial derivatives…not something I knew anything about. 🙂

    • jameslawson.ws@gmail.com

      Reply Reply February 15, 2016

      Glad you found it useful, Roxann!

  • Warren Little

    Reply Reply February 17, 2016

    James, this is a real eye-opener to me…something I knew nothing about.

    Wow, thanks for sharing,

    W. K. Little
    http://WarrenLittleBlogs.Blogspot.com/

    https://www.Facebook.com/WarrenLittleHomeBusinessCoach/

    • jameslawson.ws@gmail.com

      Reply Reply February 17, 2016

      Yes Warren, amazing… A trillion dollars is thrown around so much we don’t realize the enormity of it until it’s visualized.

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