Throughout the credit world a new development has appeared, the rising employment of derivatives. That turned out to be a bad financial experiment.
A derivative is a financial position whose value derives and is dependent on an underlying asset. Derivatives have a short time span before they expire, like an option to buy or sell. A small change in the underlying asset’s price entails a much larger change in the value of the derivative, either up or down. To take one example. If the Chicago Board Options Exchange index moves from $90 to $91, the option-derivative can go up by 33 per cent. If the index falls from $90 to $89, the loss is 29 percent. Hence, it is apparent that a speculator can do a great deal of damage. If the index fell, say by about one per cent as in the above case, the loss to the purchaser is not $90, but $1.70, the cost of the one option. Of course, institutions do not purchase only one option-derivative.
Ten years ago the face value of the derivatives outstanding was about US$700-billion. In the intervening decade, that number has climbed into the stratosphere, and currently is $516-trillion. It has escalated by another 25 per cent so far this year.
Our chartered banks have used derivatives aggressively. For instance, the Bank of Montreal reported that it lost $680-million this year on trading in natural gas derivatives. Why was that bank trading natural gas derivatives? That should not have been part of their mainline operations, and the massive loss reveals how rapidly and enormously a collapse in value can come when a financial position turns against the speculator.
Then too, the Canadian Imperial Bank of Commerce reported losing millions of dollars in derivative trading. Again, a banking institution should not engage in that kind of "monkey business." As an aside, it should be noted that the CIBC awarded millions of dollars in bonuses to the top echelons of that bank.
It is obvious that traders have relied on computer programs that ostensibly told them how to place their funds. Computers have failed to explain the relationship between a basket of derivatives and forthcoming, unpredictable events. Hedge funds buy and sell derivatives, but get mixed up by computer misinformation.
As a hedge, derivatives perhaps served some purpose, but increasingly they have become a vehicle for wild speculation. It is obvious that no one possibly could keep track of the colossal number of derivatives that traders use nowadays. It should be no surprise that banks and others have suffered big losses because of their dependence on derivatives.
Canadian banks formerly were very safe, practicing sound financial judgement; unlike those in the United States, none went bankrupt in the 1930s. Currently banks here are "playing with fire," and their actions are potentially destructive to the institutions involved and our entire economy.