Derivatives – The Real Story

QUESTION: Martin…have been wondering if you could comment, on your email blasts,something with regards to derivatives.  Who invented them?  When were they invented?  For what purpose were they brought into being?  Buffett has called them weapons of mass financial destruction, while folks like Lindsey Williams, have mentioned them as being part of the system that will be used to implode the current system and replace it with a new one, likely cashless…any light you can shed on this would be helpful….thanks very much



ANSWER: Derivatives were around in ancient times and have been a vital part of establishing any economy. While people claim that derivatives suppress prices in things like gold or create volatility in food prices as the Socialists argue in Switzerland demanding all speculation be outlawed, the truth is simple. Derivatives (Futures Contracts for Delivery) are essential to providing the economy and stabilizing it for they create a market. Without stable prices and a place to sell, producers would not risk everything on the chance someone will be there to buy it or even want it. Farmers cannot hire people and pay them without some guarantee of selling the product and locking in a profit. The same would be true for gold miners. Nobody will simply do something that costs a fortune and see if they can sell it. There has to be a market FIRST. That is the truth about all production. Claiming this suppresses prices or creates wild price increases, may sound logical to Goldbugs and socialists alike both taking the opposite side of the same issue. However, both are outright dead wrong.

Derivative contracts for future delivery were even most likely the second contract to be invented by mankind following marriage. Before there was Hollywood, the marriage contract was precisely that. It was the earliest known pension whereby the man was always 15-20 years older because he had to establish himself FIRST and then approach a woman to be his wife demonstrating that IF she married him she would be taken care of. None of the love at first sight stuff that was pure lust transformed into love to sell movies.

Derivatives are not dangerous nor weapons of mass destruction but are the foundation of a market economy. Warren Buffett had no problem trading silver all leveraged up in 1993 and 1997 through PhiBro. They are a vital part of the economy that reduced risk for farmers. They can plant now based upon what prices are today and secure a profit otherwise they cannot function without risk. If prices changed by harvest, they could be wiped out. Derivatives allow transactions for FUTURE delivery whereby a third-party buys that risk from the farmer, miner, or candlestick maker.

The “danger” comes in when derivatives are abused by banks who leverage themselves through the ceiling all out of greed with other people’s money. Whatever degree of leverage you allow, you must also understand that the leverage will reverse in a contraction against you. Hence, if you allow 10:1 leverage $1 million will control $10 million in face, but during a decline where the market falls by a normal 40% contraction you will lose $4 million leaving you out-of-pocket by $3 million assuming the magnanimous banks work for free.

Derivatives by themselves are NOT evil any more than a glass of red wine. Drink a few gallons of red wine and you may not remember your name. Everything in moderation as they say. So no, derivatives are not weapons of mass destruction and such a statement is idiotic. Likewise, they are not the instrument that will cause the system to implode and be replaced with a cashless society. You might as well say bullets kill not people. You need a gun, someone to point it, and at last for someone to then pull the trigger. The bullet does not kill by itself. It takes a human being. Eliminate guns and you will not stop murder. They have been killing people with rocks, clubs, spears and swords long before guns.

The system is imploding BECAUSE government has historically acted in its self-interest and never for the people just like the EU Commission need not listen to anyone elected. The system is imploding BECAUSE of the debt that these people borrow year after year with no intention of paying anything back and when they fear they cannot pay the bankers, they raise taxes and blame you for cheating them. Don’t be absurd. It could never be them as they insist. This has nothing to do with DERIVATIVES – it is POLITICIANS and their complete fiscal mismanagement of the state. This is like that Norwegian woman who was raped in Dubai and was sentenced for 16 months. Obviously, the whole problem is there are women. If there weren’t any women, then there would be no rape of them. Perfectly logical. Sounds strangely like the Derivatives argument from both sides. Eliminate Derivatives, prices will soar according to Goldbugs, and according to the Socialists prices would decline. Both preach to their choirs. Who is right? What they do not realize is they would eliminate the free markets and that was the precise objective of Karl Marx.