Are Derivatives Weapons of Mass Destruction? (Part 1 of 3)

By: Siyanda Pali

In a 2002 letter to Berkshire Hathaway Shareholders, Warren Buffett, arguably the greatest investor of our time, made a statement which reverberated across the financial world: Derivatives are financial weapons of mass destruction. Is this an overstatement of the status quo, a classic example of hyperbole? Or does the above genuinely hold water?

Defined as a financial contract agreement between two parties to buy or sell an asset at a predetermined date, a derivative’s value is dependent upon the price of the underlying. The underlying in question could be a share, bond, currency, market index, interest rate or a commodity such as gold, silver or corn.

The different types of derivatives include Options, Futures Contracts, Forward Contracts, Swaps, Collateralised Mortgage Obligations and Warrants.

One of the best descriptions of how derivatives function can be found in Aristotle’s Politics. Aristotle relays the story of Thales, a fellow Philosopher, but also a Mathematician, who lived around 625 to 550 BC in Miletus, ancient Greece. Thales predicts during winter that there will be a bumper harvest of Olives. He promptly negotiates with Olive Press owners for the right, but not the obligation, to rent all the Olive Presses in the region for the upcoming autumn. To secure this right, he makes a deposit with the respective parties. Lo and behold, his prediction proves to be accurate. The demand for Olive presses sky-rockets. Thales leases the presses at a significant premium, earning himself a fortune. Aristotle told this story to illustrate that philosophers, despite it not being their main aim, if they so desired, could be wealthy too. Thales may not have sought to create a financial product at the time, but he executed what today would be referred to as a Call Option.

Before the geeks on Wall Street started ‘jamming’ bonds, a product now a colossus in global finance, worth an estimated $600 trillion US in 2008, approximately $100 000 US for every person on the planet, was only burgeoning, the origins of which are quite humble. The first recorded case of organized Futures Trading was the trading of Rice in Osaka, Japan during the 1500s. Futures Trading here was simply the buying and selling of rice by merchants for future delivery. The so called ‘pre-payment bills’ were only issued in the mid 1600s. This is important because it preceded the extension of credit to the Samurai. Rice was a key commodity at the time, as it proved to be one of the only major sources of Japan’s national income. Another derivative, Corn Futures, later to be traded at the Chicago Mercantile Exchange, were created as a means of a hedge, price protection for farmers’ crops against price fluctuation, but also as a guarantee to the buyer of receiving a quality crop at a predetermined date.



Rice Trading in Osaka, Japan

International trade shifted to Amsterdam after the invasion of Antwerp by Spanish troops. The Amsterdam Stock Exchange, credited as having the world’s oldest stock exchange, was established in 1602 when the Dutch East India Company, which South Africans would later become acquainted with, sold shares in its bid to finance maritime trade across the world.
In the early 1700s, some Dutch financiers followed then William III of Orange, to London, which was also gaining prominence as a hub for commodity trading. 1711 saw the founding of the South Sea company, a joint-stock company in England with the exclusive right to trade in Spain’s South American colonies. The South Sea company’s momentum was met with stiff competition, promulgating the Bubble Act in 1720 by the British parliament, deeming illegal any other joint stock company formation, protecting the interests of the South Sea company.
1848 marked the creation of the Chicago Board of Trade (CBOT), the first derivatives exchange in the United States of America. It merged with the Chicago Mercantile Exchange (CME) in 2007 to become the CME group. Chicago, strategically positioned geographically, became an epicenter for the storage, sale and distribution of grain.




Chicago Board of Trade

The establishment of the CBOT brought about some positive changes for Futures Trading in the US from 1865. A grading system allowed the standardization of contracts with regards to quantity, quality, time and the location of delivery of commodities. The subsequent introduction of a clearing house reduced the counterparty risk peculiar to OTC trading. This was followed by the development of a margining system which improved the operational capabilities of the CBOT.

Africa boasts one of the world’s first commodity exchanges in the Alexandria Cotton Exchange. This Egyptian landmark, founded in 1861, formed an integral part in international trade, indented by increases in intra-continental trade as well as with the likes of the USA, Europe and India. Cotton merchants met here to negotiate deals, based on supply and demand, for Karnak, Menouf as well as other cotton seed varieties such as Hull, Sakellaridis and Afifi. The Alexandria Bourse, housed in Mohammed Ali Square in 1899, contributed to forming its buzzing metropolis. The success of the Alexandria Bourse inspired the formation of the Cairo Stock Exchange, which, on 21 May 1903, was targeted to operate from the premises of the Ottoman Bank as temporary headquarters. At their peak, the Alexandria and Cairo Stock Exchange combined, were rated globally as part of the top 5 stock exchanges in the world.



Cairo Stock Exchange

Such is the little-known yet significant history of the derivative market; a history which spans across national and continental lines, a history of how a grain of sand multiplied and became the vast sand on the seashores of the oceans. This is the tale of the rise of a sleeping giant.

References

1. ARISTOTLE (1920) Aristotle’s Politics. Trans. Jowett B, Carless H. W, Oxford University Press
2. BUFFETT, W. (2002) Warren Buffett’s Letters to Berkshire Shareholders. [Online] Available from: http://www.berkshirehathaway.com/letters/2002.html. [Accessed:15 October 2014]
3. INVESTOPEDIA. (2014) Alternative Investments, Derivative Securities. [Online] Available from: http://www.investopedia.com/exam-guide/series-65/alternative-investments/derivative-securities.asp. [Accessed 11 November 2014
4. KOWALSKI, C. (2014). What are Derivatives? [Online] Available from: http://commodities.about.com/od/understandingthebasics/a/What-Are-Derivatives.htm. [Accessed 11 November 2014]
5. Kummer S, Pauletto C. (2012) The History of Derivatives: A Few Milestones. Presented at the EFTA Seminar on the Regulation of Derivative Markets. Zurich. [Online] Available from: file:///C:/Users/user/Downloads/The+History+of+Derivatives+-+A+Few+Milestones.pdf [Accessed 15 October 2014]
6. MBENG MEZUI C. et al. (2013) Guidebook on African Commodity and Derivative Exchanges. [e-book] Tunisia, African Development Bank. Available from: http://www.bourseafrica.com/Uploads/KnowledgeCenterReports/2/2013/November/English/28-Nov-2013/2013-BD-SpecialReport-AfDBGuidebookonAfricanCommoditiesandDerivativesExchanges-28NOVEMBER-2013.pdf [Accessesed 15 October 2014]
7. Raafat, S. (1 November 1997) The Rise and Fall of Alexandria’s Cotton Exchange. [Online] Available from: http://www.egy.com/landmarks/97-11-01.php Accessed 13 November 2014
8. Sheridan, Barret. (Saturday 18 October 2008) The $600 Trillion Derivatives Market. Newsweek. [Online] Available from: http://www.newsweek.com/600-trillion-derivatives-market-92275?piano_t=1 [Accessed 12 November 2014]