All it took was the Chicago Mercantile Exchange joining forces with the Chicago Board of Trade and Bam! -- Chicago, not New York, becomes the largest financial market in the world once the merger is approved.
It's all because of derivatives, a sophisticated and controversial investment product that few people outside financial services even understand.
Sometime in the past 20 years, more money started pouring into derivatives than all the stocks, bonds and any other investment vehicle you can think of.
The two Chicago markets have a combined market value of $26 billion, and the underlying value of contracts they trade daily is a gigantic $4.2 trillion. Yes, that's trillion with a "t" making derivatives the dominating ruler of capital around the world -- even though some investors think they're dangerous.
One investor who issued an early warning about derivative is Warren Buffet, the so called "Oracle of Omaha" who runs one of the largest conglomerates in the world, Berkshire Hathaway. Buffet calls derivatives "financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal time bombs, both for the parties that deal in them and the economic system."
If that's so, how come they're so popular? In order to answer that question, let's take a look at what derivatives are.
What They Are
The word "derivatives" actually is actually a generic term that refers to an assortment of financial products that work like contracts. They "derive" their value from movements in things like stocks, or bonds, currencies, interest rates, commodities, and just about anything you can think of.
You "bet" that the value from the underlying asset will either increase or decrease (that's right, you can profit by someone's loss) by a certain amount within a fixed period of time, sometimes lasting 20 years. This value can be tied to a number of variables including the creditworthiness of the underlying assets.
Got it? No?
That's okay. Most people working in this business have advanced degrees in mathematical finance. You have to know about arbitrage theory in continuous time, or one-step binomial tree models, and risk-neutral valuation. Does your head hurt yet? If you didn't take advanced calculus, you may want to stop now and go back to enjoying life.
On the other hand, it's not necessary to know how a car's engine works in order to drive and enjoy one. So try to think of derivatives in the same light, otherwise your head will explode trying to comprehend the inner workings of the financial equivalent of quantum physics.
Options and Futures
The oldest and perhaps still most popular of all derivatives are options and futures. They give investors the option to buy or sell something at a later price. In this regard, they're used to hedge risk so they're used by hedge funds, pension funds, mutual funds and even some individual investors.
The recent popularity of hedge funds played a fairly large role in the surge in derivatives trading volume. Exchanges like the Chicago Mercantile Exchange and Board of Trade saw an opportunity and responded to the demand from hedge funds.
Unlike stocks and bonds, a derivative contract is a promise and the legal terms of a contract are much more varied and flexible than the terms of direct asset ownership. Actually, it's the flexibility aspect of derivatives along with their leveraging ability that makes them so popular. It's also, according to some, what makes them so dangerous.
In terms of leverage, derivatives have the ability to grow 100% in a matter of days, while the underlying security only rises a modest 10%.
Let's compare this to getting a mortgage. In order to buy a house for $100,000, you put down $10,000 and borrow $90,000 from the bank. Six months later, you sell the house for $150,000, pay back the $90,000 you owed the bank, plus interest, which is small because you only had the house for six months, and keep the rest which is nearly $60,000.
That's not a bad return for a $10,000 investment and that's the same way many derivatives work.
Leverage Works Both Ways
On the other hand, such leverage can get you into big trouble if the value of the house or underlying asset goes down. Such a scenario caused panic in the global markets a few years ago when a Greenwich, CT-based hedge fund, Long Term Capital Management, was over-leveraging something called "total return swaps" that allow for 100% leverage.
The fund had borrowed more than $100 billion on a small amount of equity capital the same year Russia defaulted its sovereign debt and Asian was in a financial crisis. Long Term Capital's derivatives went into a tailspin and the impending loss of an estimated $1 trillion threatened a number of major investment banking groups so the Federal Reserve Bank initiated a rescue operation to avoid an international catastrophe.
Despite such "meltdowns" the derivatives market continued to flourish.
In the early 2000s, stock trading was about to enter a bear market. That's when the two Chicago exchanges' saw their derivatives business really grow hedge funds shifted their bets into those markets that were doing well, such as bonds, foreign currencies and commodities.
The Chicago exchanges got another boost after the Enron collapse, which put the spotlight on the danger of private derivative deals that could prove worthless if a company defaulted on its obligations like Enron did.
A few years ago, Warren Buffet gave a speech in which he said that unless derivatives contracts are guaranteed, their ultimate value will depend on the "creditworthiness of the counterparties to them. In the meantime, though, before a contract is settled, the counterparties record profits and losses -- often huge in amount -- in their current earnings statements without so much as a penny changing hands."
Clear and Present Danger
He also predicted that derivatives will multiply in variety and number until "some event makes their toxicity clear."
We already know how dangerous derivatives are, yet we seem unable to stay away from them. They are almost like a drug on the economy to which we have all become addicted and that drug is the notion of fast and easy money. Well as they used to say, "easy come, easy go."
Let's start a countdown to how long Chicago, the derivatives capital of the world, will remain the financial capital because it's just one "meltdown" away from losing that title.
What's frightening, however, is pondering how many it will take down with it.
