demystifying the financial sector

7/31/2019 Demystifying the Financial Sector

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Demy s tif y ing theFinancial Sector

Part 1 o Corporate Watch s Guide to Banking & Finance

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ANuts & Bolts

Guide


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Contents Introduction

i) Banks

ii) Asset Management& Investment Funds

ii) Institutional Investors

v) Credit Rating Agencies

v) Products

Overview - Commercial Banks Investment Banks Proprietary Trading

Mutual Funds Hedge Funds Private Equity

Pension Funds

Credit Equity Currencies Commodities Derivatives

Banks manage the worldwide movement o money, both through the direct lending andborrowing and the acilitation o huge nancing deals, investment projects, asset trading, issuingsecurities and other corporate services.

Investment unds pool capital rom multiple investors and invest it strategically on their behal .Size and investment techniques vary, ranging rom large, low-risk mutual unds managingpeoples savings to small, high-risk hedge unds dealing speculatively in derivatives.

Te largest single class o investor, pension unds manage the retirement savings o huge numberso working people, exerting strong in uence on the markets by the sheer volume o capital undertheir control.

Ratings agencies asses the credit-worthiness o nancial products, investment projects,corporations and nation states in order to provide investors with a comparable indication o howrisky a deal might be.

An introduction to some o the key nancial products traded on the markets. Covering realassets such as loans, shares, cash, ood and raw materials as well as derivatives the complexcontracts at the heart o the sub-prime mortgage crisis.

Over the past three decades the nancial system hasexploded in both size and importance. Tis growth cor-responds to a seismic shi in the organisation o society and the global economy, in which the world o banking

and nance increasingly mediates every aspect o humanactivity. Global production, government spending, retire-ment savings and access to basic material necessities likeood, housing and medicine are all now more than eversubject to the pressures o the nancial markets. Tesemarkets now act as the central hub o an exploitative eco-nomic system which demands unlimited growth, stretch-ing people and planet to breaking point. Despite trigger-ing one o the worst nancial crashes in history, whichhas sparked economic instability and recession across theglobe, the power o nancial institutions has not dimin-ished, but rather increased. Furthermore, these marketsplay an integral role in the creation o some o the mostdestructive projects on earth, rom the tar sands to clus-ter bombs to surveillance and repression technologies.Without nance, these socially, economically and envi-ronmentally harm ul projects cannot proceed. It is there-ore vital that we get to grips with the new nancial ormsthat capital and the corporation have adopted.

Yet to most o us, the nancial system appears impenetra-ble: a mess o jargon, institutions and economic theories;the rapid transmission o data across global communica-tion networks; an alphabet soup o ever innovating nan-cial products and strategies. Its easy to eel bewilderedby the sheer complexity o the economy, and in the aceo this di culty it becomes tempting to resort to abstractconspiracy theories or re ormist solutions. But the truthabout the problems o the nancial sector is ar more un-damental; it is not an aberrant part o the economy or aew bad apples corrupting an otherwise healthy system.Rather nance lies at the very core o contemporary capitalism and acts as the primary organising principleo a global economy driven by the single aim o pro t

maximisation whatever the social and environmentalcost. Moreover, whilst hedge unds, derivatives, and thebond markets might seem like intangible entities, arremoved rom our everyday lives, in truth they are rooted

in the actions o normal people, not some secretive gango elites. Te worldwide nancial system works throughus, it cannot exist without the work we do, the thingswe buy and the debts we pay. It controls the resourceswe need to live and locks us into exploitative social rela-tionships. Understanding how this happens is key to any struggle or social change.

Tis system can be broken down and understood: it oper-ates through a global network o institutions, investorsand agencies all trying to turn a pro t rom buying andselling a wide array o nancial products. Once thesekey players and products are outlined, the pieces o thepuzzle start to come together more clearly. Tis bookletlays out the nuts and bolts o the nancial system: romhedge unds to pension unds, investment to retail banks,commodities to derivatives, each is de ned by its coreactivity and which other players and products it dealswith. It deconstructs the world o nance in clear, simplelanguage, with case studies and real-world examplesincluded throughout.

~

Tis booklet is a work in progress and orms parto an ongoing research project by Corporate Watchcalled Banking on Crisis, a series o publications andworkshops aiming to contribute to a popular, criti-cal understanding o the banking and nance sectorand its role in society. For more in ormation visit ourresearch blog at Bankingoncrisis.org, or or ques-tions, comments and suggestions, get in touch via:[email protected]

First you make money by creating productsno one understands, then you make money

by cleaning the mess up. 1

Corporate WatchIn ormation or action. Corporate critical research since 1996 .

~Bankingoncrisis.org - corporatewatch.org [email protected]

Andres Saenz de Sicilia, Hannah Schling & William DavisCopyle January 2012

1. Gillian ett, Derivative Tinking , June 2008,http://marketpipeline.blogspot.com/2008/06/derivative-thinking.html


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OverviewBanks manage the money that ows through the world econ-omy. Tey act as traditional lenders and deposit holders (seecommercial banks), direct market players engaged in specu-lation (see proprietary trading) and intermediaries helpingothers to buy, sell and hedge in return or a ee (see invest-ment banks).Tey acilitate almost every aspect o nancing,investment and trading, as well as constantly inventing newmarkets and pro t-making opportunities or wealthy individu-als and institutions. Banks make up the core o the nancialsystem, connecting all o the di erent players to each other aswell as providing logistical support, nancial advice and other

services.

Banks have grown into global juggernauts. A ew multinationalbanking groups now dominate the global economy, manag-ing the movement and allocation o capital across and withinnational boundaries. In the UK in mid-2008, only ve majorbanking groups controlled over 90 per cent o business bank-ing and 75 per cent o current accounts. 1 As commercial bankshave grown, building and mutual societies (co-operative banks,owned by their members rather than outside shareholders)have declined: in 1900 there were 60,000 such co-operativesoperating; by 2008 there were only 59. 2 A similar process o centralisation and monopolisation is evident around the world.As a percentage o GDP and domestic corporate pro ts, bank-ing and nance has also taken on an increasingly importantposition within the UKs economy: in 2006 nancial servicesaccounted or 30% o all wealth generated in this country . Tehealth and stability o national nance, in Britain as well as else-where, has become inextricably bound up with the interests o the nancial sector. Weve all heard the phrase too big to ail; asmultinational banking groups teetered on the brink o nancialcollapse in 2008, they threatened to take the entire economy down with them. Te expansion o the banking and nancesector in advanced capitalist countries has also occurred handin hand with the contraction o what is o en re erred to as thereal economy, primarily re erring to manu acturing, industry and services produced or export as well as domestic consump-tion. Government policies which aggressively promoted de-industrialisation and the dissolution o Britains manu acturingbase rom the 1 970s onwards were accompanied by programswhich acilitated the expansion o nancial services. 3 As acto-ries in the global north closed down and production moved to

1. Te No-Nonsense Guide to Global Finance , Peter Stalker, New Internationa-list, 2009, p.462. Ibid , p.463. David Harvey, A Brief History of Neoliberalism, Ox ord University Press, 2005.

developing coun-tries with lower wages, the expanding nance busi-ness stepped in to manage the transnational movement o capi-tal required by these newly globalised business operations.

Historically, the di erent types o banking activities, mostsimply divided into investment and retail/commercial bank-ing, occurred within entirely separate banks; However, theormation and development o multinational banking groupsmean that these divisions are much more uid than they were30 years ago, with many o these operations now taking placewithin the same banking groups. As a result, deposits placedby ordinary people or small businesses into a high street bank enter the global money markets in the orm o more risky investment banking activities. Highly speculative orms o investment activity, which were previously taken on only by alimited section o society (i.e. the ultra-wealthy) have becomegeneralised across a much wider public sphere, with banksacting to acilitate and manage this expansion. It is now quitenormal or pension unds, insurance companies, low-incomehouseholds and even nation states to plough their savings intothe opaque world o derivatives in some more or less directmanner.

Banks play a undamental role in deciding which projects,companies and individuals will receive unding and which willnot, mobilising investment with pro tability as the over-rid-ing priority. Tey deliberately manipulate market conditions,

contributing to the creation o asset bubbles (such as the dot-com boom in the 90s and the housing bubble o the 2000s)and commodity price rises (such as the 2008 ood crisis).Such bubbles generate massive pro ts or a tiny group o savvy investors whilst they last, but inevitably contribute tothe immiseration o millions when they burst. Te sub-primemortgage crisis is normally only thought o as the event whichtriggered the credit crunch, but in itsel it constituted the larg-est loss o A rican-American wealth in American history 4, asmillions o black homes were repossessed. On the other sideo the world, the UN estimates that 130 million people were

pushed into starvation or su ered malnutrition between may 2007 and may 2008, largely as a result o the spike in oo d pricescaused by commodity speculation.

Banks are o en at the ore ront o innovation in the sector both in terms o speculation techniques and nancial prod-ucts (or instruments). Crucially, they do not merely operatein existing markets and deal with current products, but alsoactively create new markets and investment opportunities ortheir clients. Recent years have seen the rapid expansion o theshadow banking sector, a network o largely unregulated smallbanks, investment unds and special purpose vehicles (essen-tially ront companies) built up to dodge national and inter-national controls and to avoid legal and nancial culpability when deals go wrong. Tis expansion, alongside the processeso nancialisation which have developed intensively in the last25 years, has brought spectacular pro ts or some banks andcorrespondingly enormous bonuses or bankers. UK banks

4. Martin Eakes, quoted in Te wrong way to lend to the poor , Financialimes, 19 march 2007 http://www. .com/cms/s/0/ed20af2-d5be-11db-a5c6-000b5d 10621.html#axzz1gbyo0bh7

paid out an estimated 7 billion in bonus payments or 2010, 5 whilst paying only 5.7 billion in corporation tax or the sameperiod. Such bonuses are by no means a direct orm o invest-ment stimulus in the British economy, as the vice-chairman o Goldman Sachs would have us believe when he instructs us to

tolerate the inequality as a way to achieve greater prosperity or all. 6

Furthermore, it is a structural eature o the banking indus-trys excessive bonus schemes that the majority o employees,rom CEOs to oor traders, are subject to a perverse incen-tive to undertake riskier operations with higher yields, and toengineer price bubbles and collapses in order to generate hugepro ts. For instance, investment bankers continued to createand sell the toxic sub-prime mortgage based nancial productswhich caused the 2008 nancial crisis well a er they knew they were essentially worthless because the ees generated by theircreation and sale, paid or by hedge unds (many o whom werebetting against these products), ensured they took home mas-sive bonus packages. Whilst there is a tendency to interpretsuch examples as evidence that bankers are greedy and reck-less individuals, it rather illuminates the structural impera-tive within the nancial sector to maximize short-term pro tswhilst outsourcing risk.

5. http://www.neweconomics.org/sites/neweconomics.org/ les/How_do_they_get_away_with_it_0.pd 6. http://www.guardian.co.uk/business/2009/oct/21/executive-pay-bonuses-goldmansachs

i) Banks


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Proprietary TradingProprietary (or prop) trading is when a bank trades shares,bonds, currencies, commodities or derivatives with its ownmoney, rather than on behal o a client thus making pro tor itsel rather than simply earning commission. Tese tradesare largely speculative i.e. making money by gambling onshort-term price changes.

Prop trading is a matter o degrees though, as Brett Scott hasnoted; there is a ne line between dealing activities, and spec-ulation, and the distinction gets blurred depending on howaggressive a dealing desk is in taking on risk. 1 Furthermore,

di erent banks have di erent reputations in this regard.Goldman Sachs, or example, is known to have one o the mostaggressive proprietary stances, whereas HSBC Global Banking& Markets (HSBCs investment bank) would have

a lot less, ocusing a lot more on justservicing clients 2. On average,Goldman Sachs, one o the worlds largest invest-ment banks, has madearound 10 per cent o itsincome through propri-etary trading.

Such speculative trading isrisky orm o money making, leaving banks vulnerable to large losses. Prior to the nancialcrisis, many investment banks borrowed largeamounts o debt in order to increase their positionsin such speculative trades. By 2007 the ve bigindependent US investment banks had borrowed25-35 times the value o their assets to raise cashwith which to gamble on the markets. As marketsstarted to sour and lenders recalled their loans, theinvestment banks had nothing to all back on, lead-ing to the collapse o Lehman Brothers amongst othersand the huge government unded bail-out programs.

Banks that undertake proprietary trading on a largescale o en use automatic computer algorithms in whatare called high requency trades (HF ). With HF trad-ers move in and out o markets rapidly and with a highnumber o trades, selling as soon as there is an advantageousdi erence in price. Research conducted in June 2011, oundthat HF made up 35 per cent o European markets, and 55per cent o US markets. 3 Many exchanges, such as the London

1. Brett Scott, Barclays Plc & Agricultural Commodity Derivatives, March 20112. Ibid3. http://www. .com/cms/s/0/b 3bd950-8 96-11e0-954d-00144 eab49a.html#axzz1Sdmb2dQ5

International Financial Futures and Options Exchange (LIFFE),are run solely on electronic trades and so lack the classic pit inwhich human traders shout at each other. HF can contributeto volatility, destabilising markets and prices; the USA stock market ash crash o May 2010, in which the Dow JonesIndustrial Average experienced its largest ever one-day dropin value, was caused by renzied HF activity. An investigationinto the causes o the crash declared that it was made possibleby a market so ragmented and ragile that a single large tradecould send stocks into a sudden spiral 4.

By 2007 the ve bigindependent US investment

banks had borrowed

25-35 times the valueo their assets to raise

cash with whichto gamble on the

markets.With the increasingly volatile global nancial markets,and there ore greater opportunities or speculation

ollowing the 2008 nancial crisis, the use o auto-mated algorithms and HF has increased dramati-cally. Tere have been, however, moves at both the EUand US levels to ban or limit proprietary trading by banks, particularly using HF . Whilst some largeinvestment banks have closed their own proprietary

trading desks, they, or their ormer employees, areinstead setting up separate hedge unds to under-take the trades. For example, over the course o

2010-11, Goldman Sachs closed its Global MacroProprietary rading group and its Principal

Strategies department, both o which conductedproprietary trading on behal o the bank. 5 Following

the disbanding o Principle Strategies, its ormer headMorgan Sze started a new hedge und called Azentus

Capital Management.

4. http://www.sec.gov/news/studies/2010/marketevents-report.pd 5. http://www. .com/cms/s/0/bd4d2d2a-3964-11e0-97ca-00144 eabdc0.html#axzz1Sdmb2dQ5

Mutual Funds(Unit Trusts)

Mutual unds, also called unit trusts in the UK, pool capitalrom multiple investors and re-invest it in stocks, corporate andgovernment bonds, derivatives and other assets such as money market securities like commercial paper (short-term company debt). Each und port olio (a collection o investments) is man-aged by a und manager, who is paid a ee by investors.Investors in mutual unds are highly varied, as are the typeso unds available; stakeholders range rom indi- vidual households to institutional investors suchas pension unds. For example, in the retail bank-ing world, cash held in stock and share ISAs is o eninvested into unit trusts. Investors essentially hold shares inthe mutual und, on which they are paid a yield. 1 By poolingindividual and institutional capital, unit trusts can invest largersums, and thus increase returns.

Te investment und industry body in the UK is theInvestment Management Association (IMA), rep-resenting 90 per cent o the industry. 2 IMA research oundthat, in 2009/10, IMA members were responsible or manag-ing 3.9trn o assets, and owned 38 per cent o all shares inUK companies. 3 Te research also ound that: the UK undssector as a whole has steadily grown rom a specialist nicheinto a mainstream part o household savings. By acilitatingthe investment o huge amounts o capital earmarked to sup-port ordinary people (pensions, insurance, local government

savings etc..) mutual unds represent another important way that our own interests are tied to the per ormance o the nan-cial markets; depending on their pro tability or our nancialsecurity and inadvertently acilitating to the nancing o many destructive industries such as arms and ossil uels. It is impor-tant to include mutual unds when researching who owns acorporations shares and how it generates investment.

1. http://en.wikipedia.org/wiki/Mutual_ und, http://lexicon. .com/erm?term=mutual- und2. http://www.investment unds.org.uk/the-industry-and-ima/about-ima3. http://www.investment unds.org.uk/research/ima-annual-industry-survey

ii) Asset Management& Investment Funds


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Hedge FundsWhereas mutual unds and institutional investors operate withhuge volumes o capital and a correspondingly large asset base,hedge unds are smaller private investment unds. Tey caterexclusively to wealthy individuals and institutions, and actively use derivatives and leverage to create spectacular returns oninvestments. Te Routledge Encyclopedia of International Political Economyhas termed this type o activity, speculatingwith borrowed assets. Teir risk-based strategy permits hedgeunds to engage in the kind o precarious trading activities pro-hibited by larger unds who are mandated to place nancialsecurity rather than sheer pro ts at the ore ront o their con-cerns. Hence hedge unds are seen as nimble players with theleading edge on market trends, they habitually outwit the cum-bersome institutional unds and o en pro t at their expense.In turn the institutional unds are increasingly turning to

Hedge unds to help shore up their investments. In 2004 theF reported that public and corporate pension unds, univer-sities, endowments, and charitable organisations have sharply increased the amount o money they put into hedge unds inan e ort to boost their returns and diversi y their holdings. 1

1. http://www. .com/cms/s/1/03d4d3b6-e088-11d8-9d75-00000e2511c8.html#axzz1hBE9mmtd

Like other parts o the shadow banking sector, hedge undssaw a rapid increase in size and power with the rise o neolib-eral economic policies that aggressively de-regulated the indus-try. Whilst there were about 130 hedge unds in 1996 manag-ing $130bn in assets, by 2006 there were an estimated 9,000controlling $2.9 trillion 3, which is roughly equivalent to theentire GDP o the UK. One reason or this dramatic increase

- in addition to the spectacular pro ts they generate - is theunique remuneration strategy o hedge unds. Personal undmanagers take charge o investments and in return receivea per ormance ee (typically 20 per cent o all pro ts gener-ated) as well as the usual management ee paid to und manag-ers (around 2 per cent). Tis high per ormance ee motivatesinvestment ocused on securing the largest possible returns orinvestors, irrespective o the social, environment or wider eco-nomic impacts. Bill Gross, a bond und manager at Pimco hasaptly described hedge unds as a remuneration strategy, notan investment strategy. 4 Over 50 hedge und managers appearin the 2011 Sunday imes list o Britains richest 1,000 people. 5 Given their exclusivity, Londons May air district is the mainhome o hedge unds in the UK, whilst the legal entity is usu-ally registered abroad in tax havens.banks and mutual undsare lightly regulated, but the hedge unds do not have to revealtheir holdings at all, and e ectively escape all regulation. 6

3. Nick Hildyard, A (Crumbling) Wall of Money: Financial Bricolage, Derivati-ves and Power , and http://www.h sb.org/sites/10188/ les/what_is_a_hedge_und.pd

4. Nick Hildyard, A (Crumbling) Wall of Money: Financial Bricolage, Deriva-tives and Power . Originally quoted in http://www. .com/cms/s/2/c8cbb71c-203 -11dc-9eb1-000b5d 10621.html5. http://www.thesundaytimes.co.uk/sto/public/richlist/article619511.ece6. Robin Blackburn, Finance and the Fourth Dimension , New Le Review 39,May-June 2006.

Hedge unds are easier torecognise than to de ne.However, they tend to sharecertain characteristics andare generally susceptible tothe elephant test: althoughhard to describe, you knowa hedge und when yousee it.

Short-sellingShort selling is one o the oldest speculation techniques used by hedgeunds. It is a bet that stands to pro t rom an asset alling in value. ogo short, a hedge und b orrows the asset rom its owner or a ee, thensells it on the market hoping the price will drop, the und then buysthe asset back at the new cheaper price and returns it to its originalowner, thus pocketing the di erence between what it sold the asset

or and what it had to pay or it. Short selling is a notorious tech-nique and has been banned on certain trades in the UK in recentyears. Particularly when conducted on a large scale, short sell-ing contributes to the rapid devaluation o assets, as marketsbecome ooded with supply and even those who dont holdshort positions seek to sell, pushing prices down even ur-ther (as in the example o black Wednesday).

Millions o people worldwide,both workingand retired, havemoney invested inhedge unds andmight not evenknow it

Te Hedge Fund Standards Board, quoted in Nick Hildyard, A (Crumbling)Wall of Money: Financial Bricolage, Derivatives and Power

Hedge unds get their name rom the main investmentstrategy, whereby they hedge their bets so that they stand topro t whatever the outcome o a deal. Te rst hedge undsstarted in 1940s, betting on the value o stocks going upgoing long and covering it with bets on stocks going downgoing short. Tis was a mix which ensured they would alwaysmake money. Nowadays Hedge unds cover themselves usinga variety o complex techniques such as short-selling ( seebox ), securitisation (packaging together debts and sellingthem on) as well as der ivatives and other instruments ( seeDerivatives).One major criticism levelled against hedge unds is their highuse o leveraging, which means taking on large quantities o debt in order to ampli y the outcomes (i.e. potential pro ts) o a trade. In the words o the IMF Hedge unds di er rom other

borrowers...inso ar as they tend to be highly leveraged, so thatwhen things go wrong, they go very wrong.2 Prior to the 2008nancial crisis, many hedge unds borrowed heavily againstmortgage backed securities (CDOs), leaving them with largelosses, and contributing heavily to the crazed sell-o s w hen the

value o those securities crashed during the credit crunch. By operating with high levels o leveraged (i.e. borrowed) unds inorder to undertake highly speculative trading activity, hedgeunds inject signi cant risk into the whole nancial system.

2. IMF, quoted in Nick Hildyard, A (Crumbling) Wall of Money: Financial Bricolage, Derivatives and Power

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Pension FundsIt is a largely unknown act that some o the most importantplayers in the nancial sector particularly the stock markets

- are the unds that manage ordinary peoples pensions. Teseunds, whose task is to sa eguard the retirement savings o theworking population, control more than two-thirds o all listedshares in the UK 1 and own more than 13 trillion o assetsworldwide (about 10 times the UKsGDP). Tis makes them the largestsingle class o investors, ar outstrip-ping hedge unds and private equity 2.Pension unds come in two varieties:

public and private, which are usually subject to di erent legal regulations.

By and large, pension unds ocustheir investments on long-term, lowrisk assets rather than short-term,speculative trades. In the 1940s and50s almost all pensions were investedin government bonds primarily ortheir security and stability. However,in the ace o rising prices in the70s, such bonds o ered insu cientprotection against the devaluationo savings (as prices increase, thereal value or purchasing power

o money decreases). Tus undmanagers, striving to beat in a-tion, trans erred their investments to price-linked assets suchas shares and property. 3 In more recent years it has becomecommonplace or pension unds to invest - usually indirectly

- in nancial derivatives; although, in line with their mandate,opting or the supposedly sa e, low-yield varieties.

Pension unds are overseen by trustees but investment strat-egies are designed and controlled by appointed und manag-ers, who earn a per ormance-based ee or their work. Suchmanagers are o en in act divisions o huge nancial corpo-rations such as Citigroup or Merrill Lynch, and as such seek to promote the interests not only o the und but also o theirparent company. Te exorbitant ees charged by private und

1. Peter Stalker, Te No-Nonsense Guide to Global Finance , New Internationa-list Publications Ltd, 2009, p672. Asset-backed insecurity, Te Economist, Jan 17th 2008. http://www.econo-mist.com/node/10533428?story_id=105334283. Robin Blackburn, Finance and the Fourth Dimension , New Le Review 39,May-June 2006.

managers can almost halve the growth o a personal pensionover a 40-year period. 4 Furthermore, so long as managers per-orm, that is, bring in an acceptable pro t on investments, they retain almost complete autonomy in their actions. As RobinBlackburn has emphasized, However sophisticated und man-agement becomes, it remains the case that the nominal ownersor bene ciaries o the assets in a pension und [i.e. the pensionholders themselves] have no say in how their savings are man-aged, whilst the trustees with overall authority o en do not

understand complex credit deriva-tives and the risks they pose 5. Tisdemonstrates the highly limited sensein which the actions o und manag-ers can be said to represent the inter-

ests o the mass o pension-holdingindividuals.

Whereas justtwo decadesago, wel arepolicies or theunemployed,sick, disabledand elderly were

perceived as a counter to,or insurance against, the

market and its ailings,many governments nowuse such policies to supportor bolster the marketitsel . Pensions are a primeexample.6

4. Ibid.5. Ibid.6. Ibid .

Pension und investment is premised on the idea that socialprovision can t harmoniously into a positive mo del o capital-ist growth, increasingly as a constituent aspect o this growthrather than a orm o wel are to complement it. Private pen-sion unds cement the idea that only the private sector andthe nancial markets can ul l our social need or security in old age. Accordingly, the pension system and the nancialsystem emerge as two sides o the same coin. 7 Tis has pro-duced increasingly contradictory e ects or the majority o theworking or retired population, who now see their own nancialsecurity inextricably bound up with global processes o exploi-tation and environmental destruction. For example, since the80s pension unds have contributed to a growing shareholderpressure to place share prices at the ore ront o corporationsconcerns, a shi which has stimulated huge waves o corpo-rate mergers and acquisitions, downsizing and outsourcing (i.e. job losses), union-busting, tax evasion and waste-dumping.In e ect, the stewards o labours capital used pension undsin speculative investment activity, which closed plants andstrangled communities and more undamentally, the labourmovement, in developing its pension strategies, has e mbracedtwo economic concepts market rates o return and property rights that work against its interest. 8

And all this is assuming that the stock market remains healthy.Trough our pensions we are tied to the notorious and inevita-ble volatility o the markets. Te stock market crash o August2011 wiped 250bn rom the value o ordinary peoples pen-sions9, whilst the Financial imes calculated that on averagesavers had lost one h o their pensions. 10 Advice rom TeGuardian Money is More o the same: save more, work longer,retire later. 11 Adrian Boulding, Pension Strategy Director atLegal and General, commented that: Markets go in cycles andwe will ride through several more drops be ore arriving at ourretirement...Pensions are a long-term investment. People puttheir money in and accept volatility as they go along. 12 It isquestionable, however, just how people are able to accept orreject this volatility considering the lack o personal controlover where pension unds are invested, or even knowledge that

their pension unds are so dependent on nancial markets in

7. Richard Minns and Sarah Sexton, Te Corner House, oo Many Grannies? Private Pensions, Corporate Welfare and Growing Insecurity, May 2006. http://www.thecornerhouse.org.uk/resource/too-many-grannies# n017re 8. eresa Ghilarducci, Labors Capital , MI Press, 1992, p. 1309. http://citywire.co.uk/new-model-adviser/market-turbulence-wipes-250bn-rom-pensionunds/a517906

10. http://www. .com/cms/s/2/de19040e-c297-11e0-9ede-00144 eabdc0.html#ixzz1Vy8qlFJa One month ago, a pension und worth 100,000 couldhave bought a 65-year-old man a guaranteed income or li e o 6,440 a year.Since then, i the und tracked the F SE 100 index, its value has allen to83,000 and the annuity rate has slipped rom 6.44 per cent to 6.3 p er cent,giving an annual income o 5,230.11. http://www.guardian.co.uk/money/2011/aug/05/stock-market-crash-how-it-a ects-you12. http://www.mirror.co.uk/advice/money/personal_ nance/2011/08/17/stock-market-volatility-wipes-120billion-o -value-o -pension-unds-115875-23349845/

iii) Institutional Investors the rst place. Te growing pension crisis has put lie to themyth that relying on private nancial institutions and thestock market to generate a secure pension or each individualis viable; it is clear that the supposed symbiosis o personal andcorporate interests is deeply troubled.

Pension unds are some o the largest investors in corporationswhich uel a devastating orm o growth in icting ecologi-cal destruction and human rights abuses: ossil uels, mining,mega-dams, arms, bio-tech, and so on. Te UK stock marketin particular has very high involvement rom the ossil uelindustry, meaning UK pension unds are particularly heavily invested in oil. 13 However, such a scenario also provides inter-esting avenues or resistance the success ul campaign againstmining company Vedanta Resources has seen disinvestmentby the Norwegian Government Pension Fund, Martin CurrieInvestments, the Church o England, the Joseph RowntreeCharitable rust, and the Dutch Pension Fund PGGM. 14

13. http://oilprice.com/Finance/the-markets/UK-Pension-Funds-Unhealthy-Overweighting-o -Fossil-Fuel-Stocks.html14. http://www.banktrack.org/show/companypro les/vedanta_resources


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Case study:Shin Yukawa & AbacusIn one notorious example, Shin Yukawa, ormerly o rat-ings agency Fitch was snapped up by Goldman Sachs towork on the creation o the Abacus Collateralised DebtObligation (CDO) packages. CDOs are nancial prod-ucts made rom the combination o multiple securitisedmortgage contracts, notable or their ability to counter-balance or at least mask risk; such products played apivotal role in triggering the 2008 nancial crisis. WithYukawas technical expertise the Abacus CDO packagewas granted a AAA rating the highest possible, bring-ing Goldman Sachs a healthy pro t at auction. However,the Abacus package was also created with the assistanceo hedge und manager John Paulson, who had a hand inselecting the mortgage contracts on which the bonds werebased. Paulson, predicting the immanent collapse o thehousing market, selected weak looking mortgages. TePaulson & Co hedge und bet against the Abacus packageand made a cool billion when 84 per cent o the under-lying bonds were downgraded - all within six months o their issuance. 1

For deceiving investors over the Abacus package, GoldmanSachs received a $500 million ne rom the US Securitiesand Exchange Commission (SEC), the largest ever metedout by the SEC. However, the rating agencies who played apivotal role in the deal walked away unscathed, remainingas in uential and credible as ever.

1. http://dealbook.nytimes.com/2010/04/24/rating-agency-data-aided-wall-street-in-deals/

Real AssetsIn nancial jargon any amount or part o actually existing, material things in the world is re erred to as a real asset, which can bebought and sold in the nancial markets. Tis can include parts o companies, ood, energy and raw materials, di erent currenciesor interest-bearing loans. Roughly, this category can be divided into our types o asset: credit ; equity (shares); currencies andcommodities .

Credit

Credit re ers to the borrowing and lending o money. Every time money is loaned out or saved it is actually being sold ascredit. Te price o credit is set as an interest rate, which is the

ee the borrower pays to the lender. Tis rate varies accordingto a number o actors length and size o the loan, perceivedability o the borrower to repay, availability o credit in general(known as liquidity), and so on. A savings account at a highstreet bank, or example, involves the customer selling creditto a bank, just as a mortgage involves the bank selling credit toa household. Large banks are perceived to b e stable and reliableborrowers so the interest they pay on saving is relatively low,households however are seen as less secure so the interest rateon a mortgage is higher. Interest, then, can be thought o as theprice o credit over a certain time period.

High street banks operate by buying credit rom customers at alower interest rate and then lending it out at a higher one. Tedi erence is the banks pro t. What we experience as debt, thebank views as an asset, generating interest payments and itspro t. Prior to the nancial crisis, it was relatively cheap orpeople to borrow rom high street banks, who levelled rela-tively low interest rates. Tis, alongside increased dependenceupon credit as a result o declining soci al wel are and stagnantwages, helps to explain the act that the UK has highest levelso personal debt in the world: in September 2011 the UK publicowed 1,451bn in personal debt, paying 174 million a day ininterest alone. 1 PriceWaterhouseCoopers estimates that theaverage household spends 15% o net income just to servicethe interest payments arising rom debt.

1. http://www.creditaction.org.uk/help ul-resources/debt-statistics.html

Bonds

Te so-called credit market works in a similar way, but buysand sells very large loans in the orm o bonds. Bonds are a way or investors to sell credit to governments (in the orm o sov-

ereign bonds) and companies (in the orm o corporate bonds).Like many other kinds o credit, a bond consists o a contractwhich guarantees the holder (owner o the bond) repaymento the original sum a er a set date (known as the maturity)plus a coupon (the extra interest on top o the original loan).

Alternatively, some bonds are paid o in installments (knownas amortizing bonds) rather than in a lump sum at the end o the maturity period. A bond represents an asset, which can beborrowed against and used to leverage urther capital. Te ideais that companies and governments use the money invested inthem via bonds to undertake some activity which makes back the bond money, enough to pay bond investors a rate o inter-est, and pro t or the company (or extra tax revenue or a gov-ernment). Government bonds are usually viewed as the moststable orm o investment, because a government has access totax income as a means to guarantee repayment.

Bonds can be traded in the bond market, though unlike shares,this does not usually happen in exchanges but rather via bro-kers who match buyers and sellers in over-the-counter trades.Tis means they are much less transparent, and much harder totrack than shares. Recent years have seen corp orations relyingincreasingly on bond nancing over direct bank loans. Whenbonds are publicly issued by a company, a prospectus is issueddetailing what the investment capital raised will be used or.Tis is a good place to look when researching the nancing o corporate projects.

Credit rating agencies are private companies that assessorganisations, companies, institutions, nancial products andnational economies or their credit-worthiness. A credit ratingis essentially an assessment o the ability to meet nancial com-mitments particularly to re-pay debt. It is an evaluation, orinvestors, o how risky a company, product or government is.Credit ratings are graded alphabetically, normally rom AAA(the highest, sa est grade normally reserved or wealthy andstable nation states) to C (risky or junk), with slight varia-tions in grading systems between di erent agencies and orlong or short term loans.

Tere are three major credit rating agencies in the world:Standard & Poors , Moodys , and Fitch . Tey are all private

companies in competition with each other or the handsomeees paid by those seeking a rating. Banks and other nancialcompanies employ credit rating agencies to provide a rating orthem and their products. One implication o this system is thatbanks can choose to o er business to the agencies most willingto provide good ratings or their nancial products. Tis po sesobvious problems, shown by the act that all three credit ratingagencies granted A ratings to both Lehman Brothers and AIGright up to their collapse.

Te revolving doors between credit rating agencies and invest-ment banks spin ast; rating experts are highly sought a erwithin banks where insider knowledge, experience and indus-try connections are all valuable assets or those looking toput together highly rated nancial products. Te aim o suchrecruitment strategies is to increase pro ts through ratingsarbitrage, whereby investment banks actively attempt to createpackages o securities that are awarded ratings above their real

value, thus generating huge pro t margins. Tis is made pos-sible largely through the expertise o ratings agents, who advisebanks on how to structure products so as to give the appear-ance o holding more value than the underlying assets actually do. Te ubiquity o such techniques was an important cause o the current nancial crisis as ew investors were aware just howovervalued their assets were.

Ratings agencies thus wield incredible power and in uencewithin the markets and, by extension, in politics - a act ren-dered increasingly tangible by the developing sovereigndebt crisis. Most nation states depend on the bond marketsto nance their spending budgets, issuing regular bonds torepay old debts and take on new ones. Scepticism about statenances in the context o a prolonged global recession has ledmany countries to have their credit rating downgraded by themain agencies. Tis inevitably results in lower investor con -dence and higher borrowing costs or the nations in question.

v) Productsiv) Credit Rating AgenciesGreece, Portugal, Ireland and Spain have all su ered romrating downgrades which have orced them to unroll hugespending cuts and austerity measures in attempts to placatethe markets. Even the United States has been subjected to adowngrade by Standard & Poors because o perceived struc-tural problems with the US public nances 1. Meanwhile, many other countries including Britain have implemented similarmeasures, including pay-cuts, pension reductions, increasesin retirement age and mass downsizing and privatisation o public services, all to pre-emptively avoid similar downgradesand increased borrowing costs.

1. http://www. rstpost.com/world/sp-moody- tch-the-politics-o -rating-agencies-57990.html


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Equity (Shares)A share is essentially ownership o a piece o a company. Suchownership is generically termed equity, as each share o thecompany is o equal worth. In return or purchasing an owner-ship stake, and thus investing in the company, shareholders areentitled to a regular payment, called a dividend, o a percent-age o the companys pro ts.

Ownership, in the orm o shares, is bought and sold in stock markets. A corporation gains investment the rst time sharesare issued, during the Initial Public O ering (IPO). A er thatshares are traded amongst investors, but this does not directly bring any new capital to the corporation. Given that equity amounts to partial ownership o a company, as shares changehands so does the decision-making power which determineshow the business will be run. It is this act which makes corpo-

rations liable to hostile takeovers, where outside investors buy up majority stake ownership in order to strip down a company and sell it on or a pro t. ( see Private Equity)

Equity value re ects expectations o a companys uture capacity to create pro t, as well as possible mergers and external marketand industry trends that might push up or depress company

value. Predictions are o en in uenced by scares, rumours andassessments o investor con dence, which is not only di cultto quanti y but also notoriously easily spooked. Tis produces

many opportunities or speculative trading within stock mar-kets - essentially gambling to make a pro t rom changes inshare prices. Tis is a primary way that hedge unds and otherparts o the shadow banking sy stem make their money.One o the most controversial methods o share trading seenin recent times is short-selling. Tis occurs when a share priceis expected to all. A trader borrows, or a ee, shares ownedby someone else (o en pension unds and other institutionalinvestors) and sells them on the stock market. Tey then buy them back once the share price has allen and returns themto their owner, pocketing the di erence in price. Short sell-ing contributes to the driving down o share prices and was acontributing actor in the collapse o Northern Rock in 2007,during which it was estimated that hal o the 420 millionNorthern Rock shares in the market were on loan to short-sellers.1 Lansdowne hedge und alone made $200m rom short-selling Northern Rock shares. 2

1. http://www.guardian.co.uk/business/2007/sep/22/ukeconomy.economics2. http://www. .com/cms/s/0/0d5e9ae8-73a6-11dc-ab 0-0000779 d2ac.html#axzz1Vxu1QYQr

Government BondsLike companies, the state needs to pay or its projects, be it hos-pitals, roads or warheads. Te short all between expenditureand tax income is met by borrowing rom the credit markets.Te state raises nances by selling sovereign bonds to inves-tors in the city; these generally have speci c names dependingon which government issues them, UK government bonds areknown as Gilts, whilst those issued in the US are called treasur-ies. In developing countries with supposedly unstable e conomies,governments are orced to issue bonds denominated in dollars orsome other major world currency, this reassures investors that thegovernment wont simply start printing extra money to pay o itsdebts.

Te rate that governments have to pay to borrow rom the bond mar-kets depends on their perceived nancial stability, o en as assessed by the credit rating agencies. It is quite normal or most governments tohold large amounts o debt and is not necessarily seen as a sign o badnances. Te US, or example, has the highest level o public (govern-

ment) debt in world and also one o the strongest economies. Tere oredebt is not strictly a problem or governments. Instead, the problem iswhen the cost o borrowing or states increases because their economicoutlook shi s. I a country gets downgraded it not only becomes more di -cult to buy more debt, but it suddenly becomes much more expensive or

the nation to re nance (essentially to renew) its current debts and can leadto serious nancial problems.

Sovereign bonds are issued with di erent maturity periods, varying rom aew months to several decades and are traded be tween investors on the second-

ary capital markets throughout their entire li espan. Te price paid or bondson the markets varies according to actors such as supply and demand, as wellas perceptions o the countrys economic outlook. In particular i a government

starts to look like it might not be able to meet its bond repayments, sellers willbe willing to accept much less than the original value o the bond, even thoughthe interest rate is xed to this original sum o money, as it has become a muchmore risky investment. Tis a ects the yield that a b ond pays (the interest it paysout compared to what it was actually bought or). When the price o a bond on themarket alls to lower than its ace value, then its yield goes up, as it pays the sameamount o interest in return or a smaller investment. Conversely, i it sells or morethan its original price then the yield has allen, as investors get less interest or theirmoney.

CommoditiesCommodities are goods produced or consumption whichare traded on markets. Tey include oodstu s such as co eeand grain, and raw materials such as oil, metal and minerals.rade takes place on markets called commodity exchanges. Forexample, the London Metal Exchange, based in LeadenhallStreet in the City o London, is the global centre o metals trad-

ing (no surprise when you consider that the majority o theworlds biggest mining companies are listed on the LondonStock Exchange1). Te exchange trades $7.41 trillion each year,with 95 per cent o its business based abroad. 2

Commodities are bought and sold by the companies that pro-duce, export/import, distribute and process them. Huge com-mercial trading houses such as Cargill (which deals in agricul-tural and industrial products and ser vices) and Glencore, Vitoland ra gura (the worlds three largest natural resource traders),hold massive monopolies within which producers, particularly

1. http://londonminingnetwork.org/mining-and-london/2. http://www.telegraph.co.uk/ nance/newsbysector/industry/mi-ning/8179224/London-Metal-Exchange-a-history.html

those in the global south and operating on a smaller scale, hold very little power. Tese commercial trading houses are almostall privately listed and highly secretive companies. Cargill isthe largest privately owned company in the world and owns a

global in rastructure with eed mills, port and storage acilitiesin 59 countries and operations in 130 others. In most o thesectors in which it operates Cargill controls at least 25% o themarket and is either the largest or se cond largest player. 3

But in the commodity exchanges o London, alongside therepresentatives o these companies, you will also nd nan-cial institutions speculating on changes in commodity prices.Tey buy and sell the commodities with no intention o everusing or even seeing them, directly contributing to price vola-tility, derivative contracts such as utures are key to this (seethe next section or more). Te UN Commission on radeand Development commented that: a major new element incommodity trading over the past ew years is the greater pres-ence on commodity utures exchanges o nancial investorsthat treat commodities as an asset class. Te act that these

3. Corporate Watch, A Rough Guide to the UK Farming Crisis , 2004. http://corporatewatch.org/?lid=3811


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CurrenciesA currency is the type o money a country uses. In theory its value is determined by the strength o a country s economy.However, when traded on the nancial markets, currencies aretreated like shares, commodities and other nancial productsand so rise and all according to supply and demand. I a loto people want a currency, the price goes up; i a lot o peoplesell their holding in a cur rency, the price goes down. Te valueo a currency is measured relative to other currencies e.g.how many dollars or euros you can exchange a pound or. I the value o the currency is lower, it means national exportsbecome relatively cheaper to buy or oreign countries and thusmore competitive, whilst i mports become more expensive (asthey are set in the price o oreign, and stronger, currencies).Te converse is true i a currency becomes higher in value, as isthe case in developed countries where cheap goods are gener-

ally shipped in rom abroad.

Like commodities, currencies are bought and sold by twogroups: the companies and countries who use them, and thespeculators who gamble with them. Any company involved ininternational trade has to change currency to operate in di -erent countries. Forex, the oreign exchange market, is thelargest market in the world. On average, $4 trillion changedhands every day in the global oreign exchange market in

2010, up rom $3.3 trillion in 2007. 1 Te Bank o InternationalSettlements explains that: Electronic trading has been instru-mental to this increase, particularly algorithmic trading whichis a key tool in the speculators tool box. 2

Under the post-war Bretton Woods agreement, global curren-cies were pegged to the US dollar, which was pegged to the priceo gold ($35 per ounce). Tis meant exchange rates betweendi erent currencies were much more xed than they are today,making currency prices more stable. However, ollowing thein ationary e ects o the US debt- nancing o the Vietnamwar, this became unsustainable. In 1971 Nixon removed thedollars convertibility into gold and in 1973 removed its convertibility into oreign currencies. A oating exchange ratesystem was adopted in which currencies no longer had xedexchange rates but their value in relation to other currenciesbecame determined solely by the markets. Tis opened thedoor to massive volatility and speculation in currency values.

For example, in the United States, the volume o Forex trad-ing leaped rom $110.8 billion in 1970 (10.7% o US GDP) to$5.449 trillion in 1980 (195.3% o US GDP). Tis also madecurrency derivatives an important means o xing prices andavoiding risk ( or more on this see derivatives over).

1. Bank or International Settlements, riennial Central Bank Survey: Report on global foreign exchange market activity in 2010. http://www.bis.org/publ/rp x 10t.pd 2. Michael R King and Dag nn Rime, Te $4 trillion question: what explainsFX growth since the 2007 survey? , 13th December 2010. http://www.bis.org/publ/qtrpd /r_qt1012e.htm

Te East Asian crisis in 1997

market participants do not trade on the basis o undamentalsupply and demand relationships, and that they hold, on aver-age, very large positions in commodity markets, implies thatthey can exert considerable in uence on commodity pricedevelopments. 4

Constant growth is the driving orce o capitalist social pro-duction. Tis leads to more and more use ul things beingtrans ormed into tradeable commodities, around which newmarkets and new nancial in rastructure can arise. One o themajor recent steps in commodi cation has been carbon trad-ing. Te worlds largest carbon market, the European UnionsEmissions rading Scheme was already worth $63 billion in

4. World Development Movement, Te Great Hunger Lottery: How Banking Speculation Causes Food Crisis, July 2010.

2008, and continues to grow. 5 Te current global recessionattests to a generalised slowdown o growth - we are experi-encing a crisis o capital accumulation. Alongside this we areacing a crisis o natural resource depletion and an urgent needto limit our ossil uel usage. Carbon trading is an attempt tomarketise both o these problems granting access to scarceresources and the right to pollute only to those who can pay,whilst at the same time providing a means or corporations toaccess new sources o pro t.

5. amra Gilbertson and Oscar Reyes, Carbon rading: How it Works and Why it Fails, Dag Hammarskjld Foundation, Critical Currents no.7, Novem-ber 2009.

Te ood price crisis o 2008 was directly causedby speculation with derivatives on the commod-ity markets, or example through index unds estab-lished by investment banks such as Goldman Sachs.Commodity index unds are an investment port oliowhich includes derivatives on many di erent types o commodities, including ood products, generally mar-keted to large investors such as pension unds, andcreated by Goldman Sachs (who made $5 billion romcommodities trading in 2009 alone). Index unds

allow institutional investors to invest in the priceo ood, as i it were an asset like shares, and do notdistinguish between essential products like ood andnon-essential commodities such as gold. Investing inthese index unds allowed investors to place bets onthe uture price o ood without ever intending to buy or use the ood itsel . Food commodity derivativeswere included in the index unds partly because com-modity derivatives are seen as a hedge against other

types o risk, such as in ation risk.

Te price o ood was directly a ected by the largequantities o these derivatives. Food prices increasedin line with the increased purchase o commod-ity derivatives by index unds, with the number o commodity derivatives rising by over 500 per centbetween 2002 and mid-2008. Tis large-scale pur-chase o ood commodity derivatives was unrelatedto the actual supply and demand actors o oo d itsel ,meaning prices were a ected by nancial speculationrather than how much ood there was and how many people wanted to buy it. From the beginning o 2007

to mid-2008, the price o wheat increased by over 80per cent, whilst maize rose by almost 90 per cent, pre-cipitating riots and social unrest across the develop-ing world. Prices then ell astonishing quickly, overthe space o a ew weeks in the second hal o 2008.According to the World Development Movements cal-culations, this ood price spike increased the numbero chronically malnourished people by 75 million in2007 and another 40 million in 2008. 6

In addition to the quantity o derivatives, the secondactor a ecting ood prices was that speculators weretaking up long positions in ood commodities. Tisis where a trader buys a nancial product to pro trom its price increasing in the uture. Te indexunds took up long positions with the derivative con-tracts included in them massively increasing thenumber o people and nancial products betting onthe price o ood rising. 7 Tese derivatives bet that the

uture price would be higher than the present price,indicating to commodity sellers that demand wouldpay more thus distorting the market and pushingprices up. Tey were essentially betting on, helping tocreate, and pro ting rom, a dramatic price increase,using derivative contracts as the virtual equivalent o hoarding in a warehouse. 8

6. World Development Movement, Te Great Hunger Lottery: HowBanking Speculation Causes Food Crisis, July 2010.7. All rom: World Development Movement, Te Great Hunger Lot-tery: How Banking Speculation Causes Food Crisis, July 2010.8. Nick Hildyard, A (Crumbling) Wall of Money: Financial Bricolage,Derivatives and Power , p.42

Te 2008 Food Crisis

Te early 1990s saw battles over opening up Asian econo-mies to ree markets and globalisation. Te compromisereached was that Asian governments would retain laws pre-

venting oreign ownership o national rms and restrictingprivatisation but that they would remove barriers to theircountries nancial sectors. Tis triggered a surge in cur-rency trading and brought a ood o hot money invested

into Asian nancial systems. 1 In 1997, the surge o specu-lative, short-term investment in Asian currencies suddenly withdrew, prompting a stampede by the electronic h erd, 2 a er rumours that the Tai baht was not properly backedby dollars. Events moved quickly, with attacks on Asian cur-rencies turning a rumour into reality and causing extremedevaluation: people were no longer able to buy the thingsthey needed with their wages. South Korea, which received$100 billion in investment in 1996, su ered negative invest-ment o $20 billion in 1997. In 1998, South Koreans experi-

1. Naomi Klein, Te Shock Doctrine: Te Rise of Disaster Capitalism ,Penguin, 2007, p.2672. Ibid , p.264

enced a 50 per cent increase in the suicide rate. 3

As Naomi Klein has analysed, this was a prime moment orthe doctors o disaster capitalism to administer their shock doctrine medicine: op investment analysts instantly recognised the crisis as the chance to level the remainingbarriers protecting Asias markets once and or all. Forexample, Jay Pelosky, Morgan Stanleys emerging market

strategist, stated at the time: ...we need more bad news tocontinue to put the pressure on these cor porates to sell theircompanies. 4 IMF bailout loans came with heavy conditions:radically reduced government spending, privatisation, tar-gets or increased job cuts, and total ree trade. Currency speculation had been success ully utilised to create theright political and economic conditions in which the Asianigers could be slain, dissected and re-constructed in theneo-liberal mode.

3. Ibid , p.264-54. Ibid , p.267


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Credit de ault swaps are notorious derivative contractswhich allow investors to insure securities against de ault.Much like a traditional insurance policy that you might takeout on a house or car, a CDS contract entitles its owner tocompensation i their loans de ault; in exchange or thisprotection they pay a ee. However, CDS di er rom tra-ditional insurance in that any one can sell a CDS, and o erinsurance-type protection, whilst equally anyone can buy CDS protection, regardless o whether they own the actualsecurity being insured or not. Te largely unregulated mar-ket in CDS has led to a practice known as naked CDS trad-ing, where investors take out insurance on securities whichthey dont actually own, betting that they will de ault andthus pocketing a pro t without ever touching the bad assets.Tis means that when one security de aults, multiple insur-ance claims can be made on it - and w hen a whole industry

like the housing market goes belly up, it triggers economicmeltdown! During the 2008 nancial crisis, CDS contractswere instrumental in spreading the contagion o de aultingsub-prime mortgage debt to many more investors, nan-cial institutions and major insurance companies, ultimately leading to the collapse and $85 billion bail-out o AIG, thelargest insurance group in the US. Credit de ault swapsdemonstrate how derivatives can both increase and spreadrisk, and are an example o the type o derivative contractBryan and Ra erty re erred to when predicting in 2006 thatderivatives have made it likely that any nancial crisis willhave a more pervasive and speedy impact than was previ-ously the case.6

6. Dick Bryan and Michael Rafferty, Capitalism with Derivatives: A Political Economy of Financial Derivatives, Capital and Class. p.5

in two ways: on exchanges and over-the-counter; the latter isless transparent than the ormer and largely unregulated. Be-spoke derivatives are also created by banks to capture untappedmarkets, or or investors with speci c needs; this is an exten-sion o over-the-counter trading. Barclays Capital, or example,o ers a range o so-called structured products which are de-rivatives products, packaged in such a way that they dont look like derivatives products 5. Tis allows them to expand theircustomer base to include low-risk investors such as pensionunds and local governments who are wary o possible lossesand bound by strict mandates and regulation.

5. Brett Scott, Barclays PLC & agricultural commodity derivatives, March2011, p.5

As well as hedging against risk, or more normally in additionto it, derivatives are used by traders to pro t rom short-termprice changes, o en without owning the real asset on whichthe derivative is based ( seebox Credit de ault swaps). Te large

volume o these short-term trades can contribute massively to volatility in the nancial markets and puts many traders in aposition where there stand to pro t directly rom a all in the

value o an asset. Tis exposes one o the central contradictionso nancial trading activity that by utilising derivatives andtrading techniques such as short selling, short-term investorscan bene t rom the devaluation or ailure o underlying long-term assets such as companies, in rastructure projects and evengovernment debts. In this way, nancial capital attacks its ownbasis in the ongoing processes o accumulation taking place inthe real economy.

Derivatives have generally promoted the idea that it is po ssibleto account or and counterbalance risk; that it can be worth-while to take on great uncertainty i it can easily be o set witha derivative contract. However, as the current economic crisisdemonstrates, rather than diminishing overall risk, this percep-tion has ultimately propagated an increase and generalisationo risk taking. Te Derivatives explosition in the 2000s capi-talised on a wider economic boom that was largely uelled by cheap credit and a housing bubble. But a market saturated withderivative contracts can only hedge against risk i overall levelso pro tability remain high and there is plenty o cash in circu-lation. As the boom came to an end and debt de aults becamewidespread, it was impossible to protect everyone rom theworsening credit crunch.

DerivativesDerivatives are a special kind o nancial product or instru-ment, which, unlike the real assets outlined above, do notgive the holder ownership o any actual thing like money,gold, land or sugar. However, what makes them valuable (orworthless!) is directly related to what happens in the world o real assets. Tey are nancial products which bet on the future per ormance o an underlying asset or commodity. radingwith derivatives can there ore be likened to betting on a horseduring a race: you do not own the horse directly, but place a

nancial stake on its activity. I certain conditions relating tothis external, physical asset are met in this case which posi-tion the horse comes in the race then the owner o the deriva-tive is entitled to a pre-agreed payout. Te derivative itsel ismuch like a betting slip or lottery ticket i the ticket containsthe winning horse or numbers it will be highly valuable, i not,it will be a worthless scrap o paper.

Derivatives then, In more technical terms, are agreements

between two parties which oblige the issuer to pay a ee orto purchase, return or swap an asset, at an agreed point in theuture either a speci ed date, or when some other thresh-old (normally price) is reached. Tere are three main types o derivative contracts: futures , options , and swaps (see breakoutbox). A vast array o more complex versions o these three typesalso now exist (re erred to in the industry as exotic, as opposedto plain vanilla derivatives). Derivatives have emerged on anincreasing range o commodities, assets, and even e vents orexample the Chicago Mercantile Exchange has issued weatherutures where investors can bet on changes in the weather.

Te size o the global derivatives markets, particularly over-the-counter trades, exploded between the late 1990s and the 2008

nancial crash. In 2007, the total value o the global deriva-tives market reached $596 trillion. Global GDP in 2007 wasc.$65trn, making the derivatives market roughly nine times thesize o the worlds real economy. In terms o turnover, deriva-tives constitute the largest economic activity in the world, withglobal oreign exchange markets making a staggering $1.9 tril-lion each day in April 2004. 1 Te largest growth was in the Col-lateralised Debt Obligations (CDOs) and the Credit De aultSwaps (CDSs), now notorious as the nancial instruments atthe heart o the nancial crisis. 2

Derivatives are used by investors to hedge against risk, pro-tecting their investments rom suddenly alling in value. Tey could be compared to a mobile phone contract the buyer paysa xed sum in return or the right to make a xed amount o phone calls across a period o time, instead o paying or eachcall individually and potentially spending more overall on theirphone bill. Tis technique is in act hundreds o years old; theoriginal derivative was the utures contract, which arose withinagricultural markets as a means o insurance against volatileprices and varying harvests. Tey enabled buyers and sellersto agree on a certain price or a crop long be ore the harvest,giving them security against short supplies or a ooded market.Derivatives are still used as a method o risk management, par-ticularly to sa eguard investments that are highly dependenton volatile underlying variables such as interest rates, currency exchange or the price o oil and gas.

Derivatives do not operate like a traditional insurance scheme,where premium payments enter into a pool that is then used topay out claims. Rather they are a method or exchanging risksbetween individuals: there is no pool, just a set o contractswhere someone else, with a di erent perspective on risk, is pre-pared to buy your risk. 3 For example, one investor might earthe dollar rising, whilst another may stand to lose i the dollaralls. Tey can choose to create a derivatives contract whichxes a mutually bene cial dollar price, then i the value o thedollar alls above or below this price, whiche ver side bet againstthis happening makes up the di erence or the other, thus nor-

malizing the value o the dollar to the pre-agreed level. TeEconomist there ore explains that: Derivatives can [...] helprms to manage their risks. For example, a risk-averse rmmight use derivatives to hedge against a possible rise in interestrates by shi ing the risk to an investor more willing to take it. 4

Derivative contracts can be sold and traded like any other -nancial product; they do not necessarily apply only to the origi-nal two agents involved in their creation. Derivatives are traded

1. Dick Bryan and Michael Rafferty, Capitalism with Derivatives: A Political Economy of Financial Derivatives, Capital and Class. p.62. Adrian Buckley, Financial Crisis: Causes, Context and Consequences,Pearson, 2011, p.603. Dick Bryan and Michael Rafferty, Capitalism with Derivatives , p.24. The Economists Guide to Economics

Main Types of Derivatives

Futures contracts are essentially price agreements orthe uture making an agreement to buy or sell a speci casset or commodity or a set price in the uture.

Options contracts provide agents with the right,though not the obligation, to buy or sell the underlyingasset at a certain price in the uture.

Swaps are an agreement to exchange assets or com-modities in the uture and are designed to eliminateuture uncertainties.

see: Nick Hildyard, A (Crumbling) Wall of Money: Financial Bricolage,Derivatives and Power , p.4

Credit Default Swaps (CDS)


13/13

demystifying the financial sector

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