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The Derivatives Market and Reality

Stock-Markets / Derivatives Jun 09, 2010 - 02:59 AM GMT

By: Dr_Jeff_Lewis


A market dependent on extreme leverage of already complex financial products does require at least some form of stability.  This stability, often in the form of financial assistance, was made clear in 2008 when failing derivatives speculators were systematically bailed out after losing billions of dollars and threatening the entirety of the world economy.

Solutions to Risk

Proposed solutions to the growing size and scope of the derivatives include regulation and outright banning the market. Neither of these solutions, though well intended, will truly fix the growing size of the greatest asset bubble on earth. 

Regulations miss the driver of growth, failing to recognize that the derivatives market grows based on the availability of cheap credit.  Regulations would also limit the number of market actors, which are important to maintaining stability and decreasing systemic risk.  Banning derivatives would only result in higher prices for insurance and other real life products and decrease liquidity for risk pools that help reduce the cost of insurance through the theory of large numbers.

Real Solutions

The best solution to the risks of the derivatives market is to decrease regulations on derivatives, allowing more firms to enter the market, as well as allowing interest rates to be set by the market, not by the government.  With taxpayers subsidizing the losses of large financial institutions, and dollar holders everywhere affording the cost of artificially low interest rates, it doesn't take an economics genius to understand why so many firms are wagering so much on derivatives. 

The government should have an interest in pricing out speculative wagers by allowing interest rates to free-float, thereby subsidizing production and limiting off the wall speculation.  You wouldn't bet $5 billion if you had to borrow it at 4% each year for 10 years, but you'd surely do it if you could borrow at 1%.  You wouldn't actually produce something if you could borrow at 1% and lend at 4%, but you'd produce if you had to borrow at 4% to produce at 6-8% returns.

Derivatives and the Physical Economy

The derivatives market is completely destroying the real productive elements of the economy by buying off the labor pool. 

Consider this: if you were a bright 20-something with a firm understanding of mathematics, would you rather work in banking where you can earn millions per year in risk management, or six figures at an engineering firm where you would help build safe bridges? 

The millions of dollars are looking much more lucrative, true?  What is the point in building bridges when you can make ten times the money insuring them?  However, if everyone is in the business of insurance, who is actually going to produce anything?

Derivatives are an Extension of Broken Policy

The derivatives market is a perfect example of broken government policy.  Thanks to an every expanding money supply, the bubble continues to grow in perpetuity.  And even when the bubble stops growing, such as it did in late 2008, the government sends in fresh billions to keep it growing.   At some point, the derivatives market will require more money than imaginable – and more money can only come from inflation. 

We're nowhere near seeing the derivatives market pop, and we're only partially through one of the greatest expansions in the money supply in nearly two centuries.  Be safe and be smart: hedge inflation with precious metals.  While there will always be more money, more credit, and more complex derivatives, there will never be more metals.

By Dr. Jeff Lewis

Dr. Jeffrey Lewis, in addition to running a busy medical practice, is the editor of and

Copyright © 2010 Dr. Jeff Lewis- All Rights Reserved Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.

© 2005-2019 - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.

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