A Market Bigger than the World Economy...Ten Times Over

By Dr. Jeffrey Lewis   Jun 9 2010 10:42AM

The derivatives market may be better reserved for a fairy tale. Comprising a value worth more than a decade of the world's productivity, the derivatives market is the sleeping giant of all asset bubbles. As you dig deeper into the financial underworld, you'll find that this sleeping giant may just be the puppet master of finance and government.

Take a Deep Breath

As large and powerful as the derivatives market may be, it isn't exactly some crazy conspiracy. The derivatives market is powerful because it is worth trillions and is the final exchange for packaged financial products ranging from home mortgages to bets on the weather in Zimbabwe. Everything, every decision, every product, and every market of chance can be hedged against and bet upon, and that's why the derivatives market has mushroomed in size.

Legitimate Derivatives Uses

The derivatives market is made up of roughly 100 mega financial institutions and acts as a mechanism for balancing risk. This is why you'll find investment banks like Goldman Sachs and insurance companies such as AIG all participating in this trillion dollar marketplace. 

Goldman Sachs can bet on a package of mortgages against AIG without ever issuing a single loan, allowing itself the opportunity to speculate without any of the leg work required in the more tangible business setting. While your community bank has to advertise, sell, and sign the paperwork to obtain exposure to the mortgage industry, Goldman Sachs can phone up an investment bank to make a wager on the real estate market without lifting a finger. 

This is how the derivatives market earns its real world functionality. It is in itself the largest insurer in the world, compiling every risk into one central exchange.

A Life Example

Let's say there are three friends: Jim, Bob and Dan.  Dan is always lean on money and never has enough to pay the bills. Although he's a good guy, he always owes someone money, and he doesn't exactly have the best history in paying anyone back, at least not on time. Dan, needing to borrow enough to pay this month's bills, asks Bob for a loan.  Bob agrees, gives him $200 and requests that the money be paid back one month from today. 

Later, Jim and Bob are at the bar (also known as the derivatives market).  Bob tells Jim he lent Dan $200 to pay the bills, and Jim laughs hysterically, noting that Dan is never good for his debts. Bob disagrees, testifying for Dan's sincerity. Dan, feeling good after a few drinks, and with Friday’s paycheck deposited in his bank, decides he's willing to let his money talk and offers Bob a wager. 

If Dan pays Bob back on time for the full amount of $200, Dan will give Bob $500 cash. If Dan doesn't pay back the loan under the terms agreed to, Bob owes Dan $400 cash, giving Bob a slight advantage considering Dan's spotty record. They shake on it and the deal is settled.

The Bet on Dan

The example above is exactly how the derivatives market works. If you paid close attention, you'd notice that a loan of $200 is now worth either $400 or $500, depending on who is the winner of the wager. The two counterparties, Jim and Bob, have made a wager worth multiples of the actual real life event in their own form of the derivatives market, and now they have more at stake than what the loan is actually worth. 

Now, both are highly intelligent people. Jim knows he could pay Dan $200 to pay Bob a week late than agreed and make out like a bandit with a $200 profit.  Bob knows he could give Dan the $200 to pay him back, and he could make a $300 profit from Dan's wager. 

Now, with these bets in place, they'll each try to buy Dan off, just as banks and other institutions buy the power of government and central banks, effectively changing the game in their own favor and making a gold mine in the process.

Derivatives’ Dirty Side

You've just paid witness to the dirty side of derivatives. Knowing now that they can change the rules and operations of the game to affect the outcome – and their profits – big banks have a virtual stranglehold on every event that happens both in government and in macrofinance. In doing so, the banks bring their fairy tales to reality. The $600 trillion market, though a fairy tale, can easily siphon itself into the real world...and it has.

Dr. Jeff Lewis

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Dr. Jeffrey Lewis, in addition to running a busy medical practice, is the editor of Silver-Coin-Investor.com and Hard-Money-Newsletter-R eview.com