Today we are going to look at yet another financial time-bomb (more like a so-called Financial Weapon Of Mass Destruction paraphrasing Bush's propaganda machine) that it is quietly ticking away; the Derivatives Market.

What are derivatives you ask? Simple, they are bets on price fluctuations of real assets. Bets require two parties, one making the bet and the other accepting the bet. In legal terms, they are contracts.

THE PROBLEM

What's the problem with derivatives? Size, leverage, concatenation but more importantly feedback loops.

Why size? Because at 1.5 Quadrillion USD (1,500,000,000,000,000 USD) they are about 25 times bigger than the entire world economy (a mere 60 Trillion USD).

Why leverage? Because leverage makes them extremely sensitive to small economic variations.

Why concatenation? Have you heard the expression "cross-cascading default default"? Well, that's concatenation. In today's world all the big financial transactions and contracts (i.e. derivatives) are "managed" (i.e. owned) by a very few top-notch (or so they say) financial "institutions" (i.e. banks). These banks operate in different countries and are all linked by these contracts. The consequence? One fails they all fail. Guaranteed.

Why feedback loops (and since we are at it, what is a feedback loop)? A feedback loop is a process that feeds on itself. There are two kinds of loops, positive and negative. A negative feedback loop decreases the amount of a property as it progresses, like the rabbit/wolf population (the more wolfs, the more rabbits will they kill hence there will be less rabbits and hence more wolfs dying of starvation therefore less wolfs). A positive feedback loop is the opposite; it increases the amount of a property as it progresses. For example becoming overweight (as the body increases in weight it demands more food which in turn increases the body weight which demands more food and so forth). Why are feedback loops important for the Derivatives Market? Because they increase their size (more of this below).

So let's recap. Here we have contracts which represent a nominal wealth equivalent to 25 times the wealth the entire world produces in one year. Not only that, they are extremely sensitive to small economic variations due to leverage. Not only that, but in order to play this derivatives game, somebody is on the hook for those 1.5 Quadrillion USD. Not only that, but the people on the hook for that wealth are all financially linked and are mutually dependent. Not only that but derivatives also suffer from severe positive and negative feedback loops.

Hummm…. do you think we have a problem here?

What could possibly go wrong?

A LITTLE BIT OF HISTORY AND PROCESSES

Of course this is not news. Many people have been ringing alarm bells since the 2008 economic debacle and for a little while the world seem to have paid some attention. That was then. This is now.

We are back to "normal". This is so because it could not be otherwise. We cannot turn our greed off. This is to be expected… except for politicians and standard economists who keep denying human nature.

Furthermore, in a financial world where banks have flooded everything with newly printed money, interest rates are on the floor. Simple supply and demand. The more money there is, the more banks will be happy to lend you at a lower and lower prices. Competition at work.

The only problem is that then in order to "maintain profitability" banks need to lend more and more… which is not possible because the economy in the gutter and people are simply not borrowing.

Then, there is the "other" solution. Place derivative bets and leverage to the hilt. What leverage allows you to do is to obtain significant profits based on small variations on the prices assets. This is so because profits are multiplied by the leverage factor. But even this is not enough, hence the need to "invest" insane amounts of money freshly "created" out of thin air. Hence, the 1.5 Quadrillion figure.

This is all well and good until we look at the downside. If we do so, we will notice that leverage is symmetric. It works against you if you suffer loses. Small variations in asset prices going against you will be multiplied by the leverage hence bankrupting you very rapidly indeed.

But there is a problem. As all big banks and "financial institutions" are now linked, as you go everybody else goes. Got it? Yes, it is that simple.

THE CLASSIC SOLUTION

Introducing the "classic" solution to the "derivatives" problem. As you traverse the pages of specialized websites you will find endless commentaries as to how the BIS (Bank of International Settlements, i.e. the Banker's Bank) is trying to "fix" the problem by "reining-in" those institutions that are "abusing" the system. You will also find endless discussions about how politicians and Central Bankers are "taking regulatory measures" to diminish the risk. Lastly, you will find page after page of bank commentaries and papers essentially saying: who, me?

Basically it all boils down to the following:

• More regulation to limit what, how, where and how much derivatives and leverage can be used.
• More regulation to limit where such derivatives can be negotiated.
• More regulation to provide endless information to governments as to what are you doing with those derivatives.

Hummm… does this sound familiar? Allow us to summarize:

When in doubt, regulate!

Now, without even analyzing one iota of those regulations we can unequivocally declare that they won't work based solely on previous regulatory failures. It's the old story all over again: if a regulation does not work, regulate, regulate and regulate until… well… until forever! Yes, we are that good.

The main reason why regulations fail is because of greed. Do you honestly believe that a bunch of government bureaucrats on fixed salaries can ever compete with the brightest minds that money can buy? Of course not! Don't be ridiculous!

Paraphrasing the line in the movie Jurassic Park: money will find a way (around those regulations, this is).

And then we have the problem of realpolitik. Politicians know (because they are paid… lobbied… lobbied… by the banks) that if there is no profitability there is no bank. No bank means no credit and no credit means the collapse of the entire economic system. World-wide. Do you honestly believe that politicians will actually come up with regulations that will be operational and that will work in practice; even if they could actually create them? Of course not!

The "classic" solution to the derivatives problem is no solution at all. At best is a band-aid and at worst a smoke screen.

ABOUT FEEDBACK LOOPS

So far what we have explained about the properties of derivatives is more-or-less understandable, except the piece on feedback loops. Well, here we go.

1. What is the origin of this derivative explosion?
2. Cheap money (i.e. government printing).
3. What will happen when the derivative bubble explodes?
4. Credit will cease to be available.
5. What will people do without credit?
6. Stop buying.
7. What will this do to companies?
8. Make them bankrupt.
9. Government solution?
10. Print more money; vast amounts of money and give them to banks.
11. So that banks may make this money available to people.
12. So that people may buy.
13. So that companies may continue to operate.

Rational, right?

Well, no.

There is a tiny flaw in the plan. The positive feedback loop.

If we remove all the intermediate steps we end up with:

1. Government prints money.
2. This cheap money produces derivatives.
3. Derivatives create a crisis.
4. Government prints more money to "solve" the crisis.
5. This new cheap money produces more derivatives.

Repeat at nauseum.

See the feedback loop at work?

This is precisely why printing money won't work. Sure, it may work for a while but it will only create the next bubble bigger and bigger until the entire world goes broke.

It is obvious at this point that this is no solution at all.

The derivatives "problem" is being viewed as a giant jigsaw puzzle of which government bureaucrats "must" know the full picture; hence regulation. But the question is why? What would the size and ownership of derivatives add to the solution?

Answer: Governments will know to whom should they give money to…to so-call "prop-them". It's like identifying the worst drug user in a group of people and giving this person a gigantic amount of drugs! Yeah… that makes a lot of sense… not!

THE REAL SOLUTION

The real solution is simple and its mechanisms are already here and are natural. The answer is simple: let the banks go broke. Return "moral hazard" into the markets and in so doing the banks and "financial institutions" that are playing Russian roulette with the global economy will self-regulate. If there is no saviour of last resort, either be cautious in your business dealings or be broke. There is no other option. With moral hazard in the equation greed works to defuse this ticking bomb, not to increase its size. Greedy people are cautious by nature and risk-averse.

This solution works because it introduces negative feedback into the equation. The more banks go broke, the fewer banks there will be to feed the derivative bubble. Hence, the bubble decreases in size.

The more fear of bankruptcy there is in banker's eyes, the less they will gamble, hence further decreasing the derivative bubble.

Yes, at the end of the day the solution is quite simple: let the markets operate. Freely. Nature has already found a way. Get politicians out of its way and the problem will solve itself. Hummm… haven't we arrived to this very same conclusion before? Seems familiar….

CONCLUSION

The world-wide derivatives bubble is a ticking bomb that will eventually explode probably several times, each time with worse consequences than the previous one. This much is inevitable. As for timing, well, we don't have a working crystal ball right now but as soon as it gets fixed we will let you know.

In summary, the derivatives bubble/time bomb exists only because of the actions of Central Bankers and politicians. When it finally explodes, don't let the gigantic propaganda wave that will follow sway you. Remember, we told you ahead of time and with no hidden agendas. Passed that point in time, it will be your moment to make a choice: more government or economic stability. It will be your choice.

Note: please see the Glossary if you are unfamiliar with certain words.