That is above all the case with derivatives that over the past decade have risen in volume far exceeding what the underlying asset may be. The term "derivative, taken from infinitesimal calculus, refers to an isolated aspect, or "function" of a real quantity. Thus just as in maths you may be dealing not with a function, but with its rate of growth, or the acceleration of the rate of growth or the rate of growth of the acceleration. Or leaving the field of mathematical abstraction, to get our toes on more prosaic ground, instead of dealing in roses, we might choose to deal in an aspect of roses, say their fragrance, for the great convenience of not risking the rose plant’s thorns, or the unpleasant handling of manure to fertilize them. And we can swap the amount of rose fragrance for the increase in some quality of a choice wine.

For at least a decade as the trade in derivatives and in derivatives of derivatives has taken on volume and importance. Say, for example, that we can swap a derivative of one security for another – for example the exchange rate one is traded for that of another, or the increase in the market price against the acceleration in the drop of any arbitrary exchange rate. A first degree derivative trade might be the straight swap, but beyond that it might be not just a swap but a swaption, – the option, but not the obligation to make such a trade. And for that right of choice, you would probably have to pay an up-front price – for freedom of choice does not come free. Or the option to have a counter-party buy your derivative or the entire security from you. In most such cases, since we are talking up-front obligations and payments, it makes an immense amount of difference who the counter-party might be and of what moral and financial strength. An by the time the trade in such complex derivatives exceeds many times the underlying trades in the real items from which the derivatives have been conceptually extracted, the strengths and reliability of the counter-parties can actually appear to exceed in importance the underlying statistics of the national or international availability of the commodities or securities from derivatives of which these deals have been put together.

That is why it appeared crucially important to us and a few others away back in 1992 when the world was startled to wake up to find that a speculator and his band had outgunned the Bank of England and shot down the British pound, and then went on to do similar jobs on the Italian lira and other currencies, to an immense profit for their group. George Soros personally is reported to have earned a billion dollars for his part in organizing the shooting down of the British pound. And in those remote days a billion dollars was still real money. We reformers at once called for the obvious remedy – regulate derivatives, so that we would at least know what we are talking about. Not only to prevent central banks being mowed down when they moved to defend their currencies, but that those who invest in derivatives, possibly to balance the hazards of their businesses in real commodities or real securities, at least might know who the counter-parties might be to whom they may be prepaying considerable amounts for what would be false security if their net worth were not clearly documented. For there is a vital link between such information and freedom. But here we encountered a wall of resistance, not only from the speculators, but for years from the central banks, and governments themselves. Like so many other things this even echoed in many of the international allegedly "heterodox" economic conferences that seemed to have been taken over by our stock markets. It may have been the simplest of coincidences that our deregulated banks had meanwhile become deeply implicated not only in financing such super-derivative plays, but in designing new combinations in the special derivative boutiques that larger banks have set up. That is why three of our largest Canadian banks are being sued by Enron – which in turn is being sued by the US government for its alleged misdeeds of record sort. And two of these three banks have settled out of court to the tune of almost $2.5 billion. One of them – the CIBC – as lead banker for the tradership side-play that kept many things including company losses off its balance sheet, and diverted profits from the arrangement out of its treasury.

But in the past year the importance and the magnitude of the surprises coming out of derivatives have waxed so mightily, that the entire real economy is sinking to into the role of a mere weak reflection of what is happening in the world of derivatives.

But at this point the message is important enough to bring in The Wall Street Journal as witness (16/02, "GM Poses Challenge to Derivatives Market" by Henny Sender):

"The financial travails of General Motors have become a hot topic in the credit-derivatives market, where protection against corporative defaults is bought and sold. That is because a GM default, which isn’t immediately likely, could create severe strains, or worse, in this deregulated market.

"The car maker has about $30 billion in debt. But traders estimate that more than $200 billion in credit derivatives are linked to GM. But because such derivatives don’t trade on any exchange, nobody knows for certain how much credit-default swap protection has actually been written on GM. And nobody can say with confidence that they even know who is on the other side of the trades being entered into.

"Such uncertainty is one reason that, since last year, regulators have asked participant in the fast-growing market to get their operational act together. That encompasses everything from dealing with a backlog of unconfirmed trades to figuring out who their counter-parties are when one side transfers contracts to another party. The Fed has asked market participants to report by today on their progress in dealing with these and other issues. Fed officials expect to be told that targets set have so far been met.

"Four years ago, the derivatives market was a fraction of the size of the underlying corporate bond market. Today, it is estimated at $12.5 trillion, more than twice the underlying market’s size, and it continues to expand rapidly.

"That imbalance between the derivatives market and the underlying bond market can lead to glitches and aberrations when a company defaults or files for Chapter 11 bankruptcy-court protection. That is because, to settle these trades, one side is supposed to deliver actual bonds to the other side to collect compensation. But given the shortage of bonds, bond prices can actually move up on a company’s collapse as players scramble to locate those relatively scarce bonds that may have been sold short but simply don’t exist."

What results – as a bad joke on the original – is a new version of the inverted curve relationship between shorter term and 30-year Treasury bonds that had economists and bond-traders so bemused currently.

"‘One of the areas that needs watching is that the volume or value of deliverable bonds is smaller than the value of potential claims,’ said E. Gerald Corrigan of Goldman Sachs Group Inc.

"To be sure, the market has weathered major bankruptcy-court filings, including those of energy firm Calpine Corp. and car-parts companies Collins & Aikman Corp. and Delphi Corp., and several airlines. Each time, participants worked out procedures to settle trades, by holding auctions and then announcing a price for cash settlement of outstanding trades.

"But there has been a hold-your-breath air each time. Delphi was a particular challenge because of the huge amount of credit protection that had been written on it; the ratio of bonds to derivatives was about 1:15.

"Investors eager to settle trades drove Delphi bonds much higher than expected, according to Andrew Feldstein, founder of hedge fund Blue Mountain Capital Management LP. The bonds rose to almost 70 cents to the dollar before the auction, at which most participants agreed to settle at 63 cents.

"While the process of confirming and closing out trades sounds boring and technical, such matters are linked to the sort that keep regulators at wake at night.

"Meanwhile, Mr. Corrigan is organizing a symposium on March 1 to follow-up on issues raised in a report published by the Counter-party Risk Management Policy Group II last July. The meeting will address larger issues as well in a continuing effort ‘to save the players from themselves,’ as the regulator puts it."

The real game is the present deregulated and globalized play to which the real economy is rapidly being reduced to the part of a bit player.

– from Economic Reform, March 2006