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Friday, 17 November 2017

Derivatives: The Looming Disaster

As if the total failure of government in the face of Brexit was not enough of a problem for the British state all on its own, the potential catastrophe in the area of Financial Derivatives can make all other considerations trivial.

It is very hard for me - who has been a horrified observer of the development of this market through the thirty-or-so years when it has been in existence - to get my head round what is involved when derivatives meet Brexit. Most people have never had the time to understand this type of 'product', and have never felt the need to do so. Yet as far as the international financial community is concerned derivatives are by far the largest set of 'assets' that they trade in. The bankers have induced their customers, taking in all other financial traders and pretty well every firm that does real-world business, to take part in derivative business as part of the process by which unknowns and unforseeables can be wished away from the the business scenario.

As the financial world has plunged headlong into cyberspace, the possibility of counterfactual events unsettling the market has increased. In response, very clever people have developed ever-more 'advanced' derivatives. Back in the Thatcher era, when the concept was now, most derivatives were derived from real-world events; such as the incidence of severe thunderstorms in the American midwest. Insurers found that the damage that such storms could do to crops was severe; but it was highly specific to very small areas where the storm might well destroy the crop in one large field but leave the surrounding area unaffected. Meteorologists set up businesses, equipped with satellite observation and reasonably sophisticated computer programmes, that could certify whether a storm was likely to have hit a particular farm at a given map reference on a given date: this enabled an insurer of the crop to make a snap judgement, whether to accept the claim at once, or whether to investigate whether it was genuine.

This enabled a secondary business to be established, whereby the information derived about the probability of of an event [such as storm damage] occurring could be tidied-up and used as the basis of a bet on the probability of storms causing damage. Such contracts enabled insurers, and bankers who lent money to farmers, to hedge against the actual occurrence of damage. Most areas do not have storm damage in any period, so a derivative based on the probability of a storm occurring leads to no payout: but if a storm does occur, the insurer can claim against the contract and thus meet at least some of the costs of real storm damage.

Once real-event related derivatives were deemed to be viable, there was an explosive expansion of derivative contracts. The probability of an asteroid striking New York is pretty low: but a derivative can be envisaged to cover it, and offered to firms that may be anxious about concentrating their property investment in that city; and why not earthquake damage as well? Such contracts could support insurers' capital; but they soon became a means of dealing with any possibility for loss both in the real world and in the fantasy world that the derivative creators were  erecting in cyberspace. Nowadays, any improbable 'risk' can be subject of a derivative and companies are [effectively] required by their financial advisers to place their bets on the subject matter of the derivative that they want to sell.

This huge trade in bets based on synthetic probabilities is focused on the great financial centres in New York and London. The world, led by the other countries in the European Union has bought and sold derivative contracts that are legally based in the UK: and now some clever observers have pointed out that all London contracts - ever since the market was invented - have been governed by the law of England within the overall regulatory system of the EU. Some commentators have suggested that all these contracts would become void when the UK leaves the EU at midnight on 31 March 2019: unless they can all be re-written - which is an impossible task. The ministers in Mrs May's government do not even seem to be able to understand the need to keep lorries crossing the channel taking components to and from factories in the UK and on the continent: so how can they be expected even to listen to the apparently-esoteric arguments that will be put to them with increasing urgency about derivatives [and other 'products' like options]?

This country is hurtling towards a disaster that will make the 2007-9 'crash' seem nothing. The calamity will occur in markets that the ministers probably don't want to understand: but those ministers will bear responsibility for the biggest-ever financial crisis if they continue on their present course. The headbanging Brexiteers are driving us all towards ruin: and if they succeed, they will plead innocence.

Ignorance and stupidity are no defence, in law or in the court of public opinion.

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