Finance is a support function which assists in smooth running of the economy so that there is a continuous flow of funds from those who have excess of it to those who want to use it to create goods and services for the improvement of living standards of world population at large. The players in fulfilling this function are the banks, financial institutions, hedge funds.

These players of the financial world, since last decade, have become the masters of the world economy thanks to the excessive funds available to them at negligible costs. This is accompanied by assurances from the governments around the world that they will be bailed out at unlimited tax payers expense if they manage to make losses in speculation and continue to draw obscene bonuses even if they bring the world economies on the brink of collapse. It has become the case of the tail leading the dog.

This has resulted in the world of finance been turned into one big casino primarily controlled by a handful of financial institutions. There has been a gush of complex financial products unleashed across the world which make the whole financial system extremely unstable and volatile. This applies to all the currencies, commodities, stock and bond markets. An example of such products taking over the markets are that more than 75% turnover in any markets is attributed to these products.

The examples of the complex financial products are futures and options (derivatives), credit default swaps etc. The only group to benefit from these products are the very financial institutions which create and sell them resulting in increase of speculation without any meaningful contribution to the main economy other than creating an unstable environment.

The seriousness of this problem can be gauged from the fact that the World Economy of about $57 trillion is basking under the shadow of a derivative market in excess of $1000 trillion. The notional value of derivative exposure as reported for the end of Q2 2009 for the top four derivative holding institutions are as follows:

Organisation                                            Derivative Exposure

                                                                          (Trillion $)

J.P. Morgan                                                         79.94

Goldman Sachs                                                  40.48

Bank of America                                                 39.06

Citibank                                                                31.94


Some of the products and their results on the main economy are discussed below:

•    Credit default swaps (CDS) :      

According to Wikipedia CDS A credit default swap (CDS) is a swap contract in which the buyer of the CDS makes a series of payments to the seller and, in exchange, receives a payoff if a credit instrument (typically a bond or loan) undergoes a defined 'Credit Event', often described as a default (fails to pay).

The financial players sell these products to customers for a commission and also use them as a tool for speculation and changing outcome of events for their own benefit. The effectiveness of this product can be understood from the following example :

If you lend someone $1,00,000 (can be an individual / corporate / country) and then buy a CDS for $5,00,000/- would you be more interested in getting your $1,00,000/- back or would you direct your energies in creating conditions through propaganda (media) that facilitate in your borrower defaulting whereby you get to collect $5,00,000/-.

In this trade you don’t have to even lend $1,00,000/-, you can just take a CDS for $5,00,000/- and then spread rumor that the borrower is bankrupt causing other lenders to draw their loans to the borrower leading to his bankruptcy and collect your winnings.

Alternatively you can just create a rumor that the borrower is defaulting causing the cost of CDS of that borrower to increase substantially and then sell your CDS at multiple times the value of which you had purchased it.

The possibilities are endless but they are of little help to your borrower who might have taken the loan to manufacture some product or services for profit other than create an unstable environment for him to work in. This is similar to taking a fire insurance policy on your neighbors house for which you are the beneficiary of the claim if the house burns down and then enticing others around you to burn your neighbor’s house so that you can collect the claim.


Derivatives (Futures and Options)

According to Wikipedia  “ Derivatives is the collective name used for a broad class of financial instruments that derive their value from other financial instruments (known as the underlying), events or conditions. Derivatives are used by investors to

•    provide leverage or gearing, such that a small movement in the underlying value can cause a large difference in the value of the derivative

•    speculate and to make a profit if the value of the underlying asset moves the way they expect

•    hedge or mitigate risk in the underlying, by entering into a derivative contract whose value moves in the opposite direction to their underlying position and cancels part or all of it out.”

The derivatives are effective tools for hedging your exposure to markets or movements of the prices of underlying assets but are used mainly for leveraged speculation. The turnover of derivatives in stocks, currencies or commodity markets is multiple times that of actual cash turnover / delivery based turnover. This results in heightened volatility and the risk of entire financial system getting shut down.

The old age economics says that the price of a product is determined by it’s demand and supply. The present financial institutions, thanks to their gambling ways, have changed it to “The price of a product is whatever the speculators want it to be”. Using leveraged derivative positions and with enormous money power they are in a position to alter the price of any commodity, currency or stocks to the price which suits their motives without much dependency on the actual demand or supply of the same.

The consumption for oil (in barrels per day) has declined in 2008 compared to 2007 and then again declined in 2009 compared to 2008 without any disruptions in its supply. This has not stopped the oil price to shoot up from a low of $40 per barrel in March 2009 to $80 in March 2010. Similarly the consumption of gold has fallen from 3805 tonnes in 2008 to 3385 tonnes in 2009, a fall of more than 11% (Source : World Gold Council) but its prices continue moving up with bouts of volatility.

This is a direct result of changes in speculative derivative positions in the  commodity markets and not due to any change in its actual production or consumption. Moreover the price movements are extremely volatile due to the trigger happy trades which move the prices sharply both up and down on flimsy rumors. The basic mechanism of price discovery has been terminally corrupted because of the large speculative community using leveraged products like derivatives. The media and news channels play an important role in assigning logic to the price movements however ridiculous they may sound.

This defective mechanism of price discovery has effected every aspect of currency, equity, commodity and bond markets causing a great hardship to the world population at large who are the actual consumers of commodities and genuine investors who use currency, equity and bond markets to invest their life savings with an aim to have a comfortable life style after their retirement.


Effects of the Speculation on World Economy

The price of a product is now derived by the manufacturer/producer reaching the consumer of the product after passing through hundreds of speculators resulting in a product costing the manufacturer/ producer say $10 per unit costing the consumer $80 per unit resulting in cost increase in price due to speculation by $70 per unit. This price discovery method does not add any productive value to the improvement of the life of general population and is beneficial only to the speculators.

The negative effects of the rampant speculation is borne by the consumers and businesses using these commodities. The financial institutions make a few hundred million dollars in profits in speculative trading whereas Trillions of dollars are spent by the users of the commodities to purchase them at artificial high prices.

•    Everyone $1 increase in price oil results in worldwide consumers shelling out more than $18,000,000/- per day to maintain consumption (World Oil consumption was 18.7 million barrels / day in 2009). The speculation in oil markets causes prices to change sometimes $5 in a single day.

•    The fall in demand of gold due to the large price variations has resulted in lots of jewelers finding difficult to earn a livelihood. This is applicable to most of the traders of commodities for actual consumption. The costs of producing almost every product increases substantially due to the trading activities, the brunt of which is borne by the common man.

•    Speculation plays a major role in food inflation worldwide. Consumers finding their incomes and savings decreasing have to shell out more and more money to eat the same quantity resulting in a decreased standard of living.

•    Manufacturers and actual users of raw materials like copper, steel etc face a lot of problems in fixing their costs due to the volatile nature of the commodities. This has resulted in the manufacturers increasing the prices of their finished products leading to a fall in demand for them hampering their profit abilities. They have to spend more to hedge themselves against commodity and currency fluctuations further reducing their profits.

•    This also results in reduced tax collections for countries because the incremental taxes the speculators pay is much less than the resultant tax losses due to shrinking in the businesses in the main economy resulting in a strain in their fiscal positions. In developed countries the result of slow down in the economy results in increased unemployment increasing the costs of unemployment benefits.

•    The speculation activity also results in misallocation of resources. Students choose to study the fields of derivative and currency trading lured by the prospects of earning huge remuneration thereby bypassing the fields of environment or science where they can positively contribute to the living standard of the human race.


Solution to the Financial Crises

There is a very simple solution to problems which caused the world financial crises which is still spreading at an alarming rate and getting worst by the day. Now we have countries on the brink of defaulting on their debts because of the lack of their ability to restrain their habit of living beyond their sources of income. The only improvement in the economy is temporary due to

1.    Restocking of inventories and

2.    The governments deciding to promote specific industries like housing and auto through housing tax credit and cash for clunkers schemes by throwing billions of dollars at them. The demand for these too will fade as the schemes come to an end which effectively bought the future demand forward. Anyone planning to buy a house or a car in the next one year has done so now to avail the schemes / incentives.

The media makes lots of efforts to spin the news about the world economy positively however negative the economic data might be by lowering expectations or trying to assign logic to the erratic price movements in various markets.

The markets even on intra day basis move exactly opposite to the positions take by most of the traders. One example of how the financial institutions make money are by writing options for a premium and with their money power make the markets move in the opposite direction to reduce the premium values and then buy them back at a profit. It has little relation to the fundamentals of the underlying assets. Every million dollar profit these institutions make by controlling the markets, thousands of traders loose thousands of dollars.

The financial crises can be stopped from spreading by

•    A total clampdown on the speculation by the Financial Institutions and hedge funds.  Restriction on proprietary trading and not allowing the banks to use public deposits for trading is a step in the right direction.

•    Banks should be restricted to accepting public deposits and lending them to the actual users. They should not be allowed to indulge in trading for speculation. The size of speculative financial institutions should be restricted so that they are not able to pose any risk to the main economy.

•    Reduce the role of Derivatives and CDS to hedging by making it a prerequisite to own the underlying asset in order to take a derivative position on it. The margins for derivative trading too should be increased substantially so that it discourages speculation. This will also result in limiting the derivative positions to the quantity of the underlying asset.


Why Financial Regulation or Reform is a Remote Possibility

The latest US Securities and Exchange Commission filing by Goldman Sachs reveals that in 2009 the firm made more than $100 million in daily trading profits  on 131 days, an average of every other trading day. It lost money on only 19 days, and on the losing days none of the losses exceeded $100 million. This is the kind of profits speculators are making these days.

There is little probability of any meaningful financial reform being passed due to the following reasons :

•    The financial institutions engaged in speculation make billions of dollars of profits and are a main source of election contributions to politicians who are responsible for making the rules for reining their activities. Moreover these institutions have their ex-employees placed at key positions of power responsible for taking the financial reforms decisions. They also use their money power including media to create a feeling of fear amongst the public implying that reducing their role will be harmful to the public at large.

•    The politicians take up office for a fixed period of time. Their main intentions are to postpone the problems till their tenure ends. Very few would be interested in taking the bull by the horns. The politicians are more interested in appearing to be doing something and maintaining their popularity without getting on the wrong side of their contributors.

•    The flow of funds has become global whereas the rules and regulations governing them are country specific. This gives the controllers of the derivative markets flexibility to keep their operations away from regulators in the countries whose rules suit them.

Any reforms which will be passed will be very dilute and the powerful financial institutions will find ways to by pass them so as not to effect their profits and bonuses.

Financial reforms will only happen when the law makers have no other option but to clampdown hard on these financial institutions under the public pressure after the next major crash in asset prices. By then it would be too little too late. Unemployment would have shot up and millions would have lost their life savings and livelihood. Till then the world casino is on 24/7.

So its up to ones own self to protect their net wealth from the field of speculation. Be careful out there.

About the Author

I am an MBA Finance from the University of Sheffield, 1992 and have more than 15 years of experience in the field of Financial Management. I am a keen student of the Flow of Money around the World and enjoy studying the fields of Currencies, Stock markets, Commodity Markets and Bonds.

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