The Exploitititve Nature of The Derivatives Market
Derivatives have been used to reduce risk for centuries, its usage can be traced all the way back to the Babylon age BC. Given the nature of risk and how most people tend to avoid it, it's not surprising that derivative instruments and contracts became popular. But with the progress of markets, trading and the emergence of capitalism in the last 3 centuries, the derivative market matured a lot and became much more complicated than ever. 19th century booming United States, specifically its agriculture sector, who its workers and farmers struggled with the uncertainty of selling their crops, which had led to a loss of potential profits and growth to said sector. Come 1848, the need of such risk hedging platform created the "Chicago Board of Trade", the first platform to offer standardized contracts for anyone to buy or sell. The offerings mostly consisted of Forward contracts labeled "Future Contracts", and buyers and sellers would gather up in a trading platform called "The Pit" and trade through open-outcry. Later on with the rapid development of technology and the growing internet era, trading expanded into online platforms and became faster and more efficient. Of course there is also over the counter (OTC) trading, when two independent parties trade customizable contracts with next to no regulations. The derivative market proved to be a huge success, in fact the CBOT issued its initial public offering in 2002, and the OTC market value reached the trillion dollars in the 2000s (BIS, 2020). Participants in the market are mostly consisted of big organization and corporate funds, in the individual side, it can be difficult to benefit from this market. Participants can be categorized into four main goals, and those goals can be for hedging reasons, speculation, arbitrage and margin traders. Critics always saw the derivative market as "legalized gambling" is there any truth to that? And is there more to that criticism? This paper will discuss more of that side.
Derivatives are just that, a derivation of an underlying asset's value. A legally binding contract for speculators who are looking to hedge their position by pre-selling or pre-buying this contract. The underlying asset can be a physical commodity like rice, wheat, gold etc. Or a financial asset like stocks and bonds, and even currencies and market indices. A buyer of a derivative is said to be taking the "long position", and a seller is taking the "short position" AKA shorting.
One of the most repeated criticisms of the derivative market, it's how unfriendly it is to individual investors. This market is huge. with around trillions of dollars floating worldwide, and it's mostly leveraged and highly volatile. A small change in the interest rates can result for an individual who is not educated enough, to lose their whole pension plan. Which lead us to another issue, complexity. There are so many moving parts in the market and it can get overwhelming for an individual to comprehend and understand the amount of risk they’re about to undertake. Not to mention the vague nature and the non-willingness for the market to disclose the risk of major contracts. In fact, a recent study shows that 62% of retail investors in india are of the opinion that derivatives are pure gambling (Pasha,2013) , just full of speculative and highly leveraged instruments, which increases the risk by a significant margin. Warren Buffett in an interview, described derivatives as "dangerous" and "a danger to the system", stating the fear of discontinuity within the market can lead to a crippling loss for individuals and he advised in another interview to reduce the use of them when applicable for corporations. The best way to go about this for retail investors is either to acquire the skill set and the knowledge needed to engage in this marker or hire people who do.
Since Retail investors are skeptical of the derivative market, and for good reasons, then who mostly partake in this market? Institutional investors like large companies, manufactures and rich individuals through a professionally managed hedge fund. The former two examples most often than not use derivatives for its purpose I.E hedging their position against currency risk, interest rates and commodity price fluctuations. However, the latter example uses derivatives in a much insidious way. Hedge funds are a massive industry with trillions of dollars, and that much money means you can influence the market and shape it for the benefit of the funds itself. One way of doing that is by looking for underperforming stocks, and bet on their loss by short selling in some cases and using put options in other. The best case scenario for the hedge fund happens to be when the targeted company's stock is priced next to nothing, and by shorting or using put options, that process can be accelerated. And greed can cause this process to be repeated over and over until the targeted company goes under. Of course when a company goes bankrupt, that means loss jobs, a weaker competition in the targeted industry and other investors cashing out with a loss. That's a single hedge fund can make up to $60 billion dollars in a single years (Mott, 2018). It's not only unethical, it's theft, completely legal theft. But should it be? This much market manipulation is noticed and banned in France, Spain, Belgium and other European countries in order to stabilize their markets.
Where most derivatives derive their value from an underlying asset, either from a financial asset or a real commodity. Event derivatives are contracts that are backed by the likelihood of an event to happen. Events like the outcome from a football match, or which political candidate won the election, and even the weather. The more likely of the event to happen the more value that it can be derived from it. It's basically literal gambling, that is marketed to the crowd as an "Investment" which is not only predatory and exploitative but it's also outright wrong. Event derivatives can be found in the prediction market, and they're been around for years (Schor, 2018). Advocates for the prediction market will state how important it is, as its works as prognostic tool. A tool that helps originations in these sectors whom which those bets are about. Get some consensus from the public. The problem with that statement is that it overlooks the fact that there are millions of dollars at hands, people are drawn by these false advertising tactics just to go on and lose a huge sum of money. There are different ways to get some consensus from the public without resorting to gambling. Academic, political and sports based surveys have been conducted continuously, the answers for these surveys can be submitted through an online platform or in the streets for a total price of zero. Not to mention the incentives of the prediction market can be macabre and unethical. Some contracts bet on the death of a Politian or a public figure, or even to bet in an outright mass shootings through a submarket called "The assassination market". These dollars are exchange in the wish for person to die, and you can imagine how inhumane and harmful this can be. If millions of dollars are in the line for a person to meet their end, it implicitly incentives the commitment of murder with a diluted trail, which makes it harder to perform investigations into these crimes. These inhuman bets can be found in a prediction market called "Augur". And Augur is not some dark web hard to find site, it's just few clicks from anybody. In fact it's been funded through an ICO in 2015, and it holds $1.5 million dollars at its stake (Floyd, 2018). It’s a decentralized site where no single entity is controlling it, not even governments have a hand on them. These type of derivative bets should not be tolerated and should be completely criminalized and cut out from the prediction market. And the best way to do that is by heavy governments regulations in the whole market. Toying with people's lives should not be a part of the financial market.
The Saudi Exchange (Tadawul) has added derivative trading in 2020 as a part of the Financial Sector Development Program FSDP. The genie is out of the box, and it will quickly develop to an unwieldy market instrument that resembles Las Vegas' casinos, where the profits are privatized, and the losses will be shared. Derivatives started as a hedging tool, a way for farmers and manufacturers to increase their income and therefore their quality of life, and the market somewhat resembled what would most call an investment vehicle. But as time progressed the market regressed into an exploitative gambling scheme with the word investment as a way to justify it. Now it's used for hedge funds to get small companies out of business, individuals cheated out without the proper education and prediction markets begging for a person to die to get their payday. A government intervention to get this legalized gambling under control and outright criminalize some part of this market is a late but a needed change.
References
BIS, .. (2020, November 09). OTC derivatives statistics at end-June 2020. from https://www.bis.org/publ/otc_hy2011.htm#:~:text=The%20gross%20market%20value%20of,increases%20in%20interest%20rate%20derivatives.
Mott, A. (2018, August 27). How Much Do Hedge Fund Managers Make? , from https://work.chron.com/much-hedge-fund-managers-make-23556.html
Pasha, S. (2013, August). RETAIL INVESTORS’ PERCPTION ON FINANCIAL DERIVATIVES IN INDIA. from https://core.ac.uk/download/pdf/328023806.pdf
Schor, L. (2018, June 20). Explained: Prediction Markets. from https://schor.medium.com/decentralized-prediction-markets-explained-d9f0425d331c#:~:text=A%20prediction%20market%20is%20a,on%20future%20events%20or%20outcomes.&text=Prediction%20markets%20are%20basically%20event,probability%20of%20an%20outcome%20materializing.
Floyd, D. (2018, July 25). The First Augur Assassination Markets Have Arrived. from https://www.coindesk.com/the-first-augur-assassination-markets-have-arrived