- Derivatives – a demon sucking the world dry!
- Home loans, Oil Price, Weather – Derivatives gamble on everything!
- A cut from our electricity bill goes to gamblers!
- How globalized gambling started driving our lives
- They own your loans, your income and your life – how to take it back?
- How the 1% drove 99% to debt and destruction – US experience
- Capitalism – Titanic without life boats for the masses!
- How to save the world from the capitalist madness!
We use electricity for home and commercial purposes and pay the bill every month to the electricity board. Similar to the bank service charges for card payments, modern capitalistic electricity distribution structure includes a finance charge. There will be someone betting on whether we pay the bill on time, how much our bill will be and so on. The cost of that financial bet is passed on to the consumer.
This is just one example. Extend this logic to the homes we buy on borrowed money, education loans a student takes to complete higher studies, price of wheat received by a farmer and many other activities which are increasingly being linked to the great global financial gambling circuit.
To further our understanding about derivatives, one of the corner stones of global financial markets, read on for the third part of analysis of derivatives markets by Dick Bryan and Michael Refferty. This was originally published in Socialist Register vol 47 in 2011
How are derivatives priced?
The critical technical issue is how to price risk: at what prices is unwanted risk worth retaining because it is too expensive to sell; at what price is risk worth buying? Historically, there were calculations based largely on experience and intuition, but since the 1980s these are issues that have been thought of in markets as formal, technical problems, with technical solutions. Along with actuarial data, the Black-Scholes options pricing model was thought to have provided the solution12.
Two ever-present problems, however, have been made stark by the recent financial crisis.
First, when a buyer acquires a calculated risk, and incalculable uncertainty goes along with it. When markets become volatile, and there is an atmosphere of unfamiliarity, incalculable uncertainties are more likely to be revealed.13
Second, markets trade not just current risk, but expectations of future risk, and hence expectations of where the risk calculations are likely to go.
McKenzie argues that once the formula was put into practice by derivative traders, it ceased to operate as a predictor of price, and became a benchmark from which price varied.14 In effect, the pricing of risk will tend to run ahead of the technical calculations, as traders seek to beat or at least anticipate the market’s next moves.15
Derivatives are commodified risk. However, the conception of ‘risk’ as a commodity stretches the popular understanding of a commodity, especially where the popular conception is (still) conceived as a physical output produced in a factory. Indeed, this contrast is often at the basis of the argument that there is something ‘unreal’ or ‘fictitious’ about derivatives.*
The argument itself has a lineage going back to at least to the development of the joint stock company, when the ideal of fictitious legal entity (the ‘corporation’) becoming an owner of capital was similarly questioned.16 Contrary to this popular conception, we contend that derivatives are both real and integral to accumulation, albeit also objects of speculation. Hence, there is a need to grapple with the logic of derivatives in order to understand accumulation more generally, including the circuit of industrial capital (the stylised ‘factory’ model of accumulation).
Two points are pertinent here.
First, the circuit of industrial capital starts with money capital in the form of credit or equity. But the interest rate on the credit and the price of equity changes in uncertain ways over time17, and hence the ramifications for the share of produced surplus that must go to the lender or investor. The sale of output generates revenue, but perhaps in a currency of unknown value at the time of payment. There are risks of disruptions of all sorts to the production process and risks in consumer demand. Contingency is central, and to omit it from a depiction of nature of industrial capital involves not a abstraction from, but idealization of, market processes. It is the idealization of an equilibrium model.
Second, on the circuit of industrial capital, exchange value is thought of as embodied in commodity output, and when the commodity is sold for final consumption, it leaves the sphere of competition. In the case of a derivative, competition is embodied in the substance of the product: the exchange value is located in what the product does, or what it sets in motion, and what it sets in motion is competitive calculation.
In the case of car insurance, to take a simple example – a product with option-like dimensions – the insurer faces costs of repairing smashed cars plus their administration costs. To that they seek to add a certain rate of profit. But for a consumer, the value of the commodity purchased is not a certain amount of repairs but the right to repairs (the right to set production in motion) should your car get damaged. The commodity output is a contingent claim on production.
With a different sort of derivative, such as security based on the income stream of household electricity payments, the existence of the security means that the payment for electricity by households is not simply an act of consumption, constituting the end of a process of electricity production and distribution. Here the payment itself becomes the basis of a traded product and the security stays in circulation. Hence, unlike the depiction of a circuit of industrial capital, where commodity output ‘leaves’ the sphere of capital, derivative commodities remain in circulation. We have elsewhere called them ‘meta-commodities’ but equally they may be thought of as ‘meta-capital’ because of their capacity to blend across the circuit of capital as a whole.18
Why might derivatives be central to understanding accumulation?
Framed as distinctive sort of commodities**, there is an inclination to cast derivatives analytically at the margin: as conceptually different and functionally marginal, and hence also as dispensable. The proposition above, however, point in quite a different direction. The distinctiveness of derivatives is that they can create new sites for accumulation and news ways of disaggregating and re-aggregating circuits of capital.
They facilitate the imagination of vast ranges of novel commodities, which, once conceived and produced, seem to have almost insatiable demand. The key to this imagination is that things we have formerly thought as singular, total entities can be decomposed into constituent dimensions, with each dimension then conceived as a discrete risk, and hence as a discrete risk-based commodity.
A loan, once conceived simply as credit, is now decomposed into interest rate risk, foreign exchange risk and default risk. Interest rate risk can be broken down into, for example, the risk of divergence between different base rates for calculating variable interest rates (e.g. LIBOR or the US prime rate) (basis risk); risks of prepayment of loans (options risk), risks of changing differences between short-term and long-term interest rates (yield curve risk), and so on. Each of these risks can be priced discretely and traded at a rate of billions of dollars a day. And each of these risks can be decomposed into multiple subsets, opening possibilities of new products, tailored more and more precisely.
At issue is whether this process of segmentation, quantification and commodification can be constituted as a contribution to accumulation in the sense of creating new value, or is simply a redistribution of the surplus (created in the ‘real’ economy). A full engagement with this issues is beyond the scope of our analysis, although it can be readily contended that there are elements of both. But if the growth of derivatives is seen simply as redistribution of the surplus, we miss the momentum that is driving the formation of new derivative products and the specific for these innovations are taking. Framed in this way, derivatives can be posed as opening up new frontiers of accumulation which are generally located within already existing activities, but giving those activities new commodified dimensions.
Loans have long existed, but decomposing loans into commodified risk attributes is a new invention. Moreover, what can be done for loans can be done for many facets of economic and social life. We may debate whether these initiatives actually make life better, just as we could debate the merits of advertising or many facets of the legal industry.
Derivative market development is conceived within an agenda of precision of calculation: an agenda that is integral to the logic of capital. The effect is to extend the calculus of finance and risk into wider social domains, and this, perhaps is the underlying dynamic of what is being called ‘financialization’. From this perspective, we can look at how derivatives have evolved in the recent past and may potentially develop as expressions of this calculative logic.
* Compare the discussion presented here, about fictitious capital and credit as commodity with Marx’s discussion of fictitious capital in Capital – Volume 3
“The stocks of railways, mines, navigation companies, and the like, represent actual capital, namely, the capital invested and functioning in such enterprises, or the amount of money advanced by the stockholders for the purpose of being used as capital in such enterprises. This does not preclude the posssibility that these may represent pure swindle. But this capital does not exist twice, once as the capital-value of titles off ownership (stocks) on the one hand and on the other hand as the actual capital invested, or to be invested, in those enterprises. It exists only in the latter form, and as share of stock is merely a title of ownership to a corresponding portion of the surplus-value to be realised by it. A may sell this title to B, and B may sell it to C. These transactions do not alter anything in the nature of the problem. A or B then has his title in the form of capital, but C has transformed his capital into a mere title of ownership to the anticipated surplus-value from the stock capital.” – Chapter 29, Component parts of Bank Capital, page 466, Progress Publishers, 1959
** To understand the value of a commodity read Chapter 1 of Capital Volume 1 by Karl Marx. The views presented in this paper about the nature of commodities are not entirely accurate
*** To understand surplus value creation and capture in different phases of capital circuit, study Part IV (Merchant’s Capital) and Part V (Interest bearing capital) of Capital Volume 3 by Karl Marx. The views presented in this paper about surplus value creation are not entirely accurate