Death by Derivatives

https://www.damninteresting.com/death-by-derivatives/

by pepys • 9 years ago

101 71 9 years ago

skrebbel• 9 years ago

Indeed, the string of early derivative traders taking their own lives grew long enough that one writer gave it a name: the “crimson thread of suicide.”

I fear the day that Bitcoin & friends come crashing down.

jstanley• 9 years ago

During the 2014 crash there were details of suicide hotlines pinned to the top of r/bitcoin

amelius• 9 years ago

A more ironic title would be "Death by Securities".

jstewartmobile• 9 years ago

If you haven't yet, read his story on Colonel Sanders. You can thank me later.

https://www.damninteresting.com/colonels-of-truth/

goldenkey• 9 years ago

That was an awesome read. Never knew the Colonel was a real person. A little sad how they managed to screw him over with no stock considering he founded the company. Good news though as of late, is that KFC is going back to its roots: http://www.bizjournals.com/newyork/news/2016/04/04/kfc-redo-...

Might have to try it again :-)

dsacco4• 9 years ago

That was a nice read. I like these pieces about the historical context of financial instruments.

Michael Lewis details one such practice in his book Flash Boys, where market makers use superior networking technology to change the market price of a security after a customer sees it and places an order, forcing them to trade at an inferior price.

This is a potentially misleading description of HFT algorithms. HFTs cannot see a customer’s order before it executes on an exchange. They cannot “jump in front of” an atomic order. HFTs only have insight like this at the inter-exchange level, i.e. in latency arbitrage. But by default a customer’s order won’t be routed to multiple exchanges unless there is insufficient liquidity to complete the order on the first exchange (which, if that’s routine, means you’re likely an institutional customer). Alternatively, if they submit several orders, HFTs will (logically) adjust their prices in response to the new order book activity, which would result in price slippage for the customer.

cryptonector5• 9 years ago

HFTs == market makers. You need market makers in order to have a functioning, liquid market. Absence of market makers -> higher volatility.

Market makers can lose a lot of money under certain market conditions. Their profit margins are rather small. Market makers are practically heros.

vinceguidry• 9 years ago

It's a bit naive to equate the two. Plenty of strategies can be found that leverages high transaction speed and volume that aren't market making.

What defines market making is the fact that you buy and sell the same commodity at the same time, taking advantage of the spread to make money.

Two other rapid transaction arbitrage strategies involve market manipulation, in which trades are placed that are designed to fool other trading algorithms into believing that the price is going to move a certain way, and statistical arbitrage, which searches for temporary price differentials across exchanges.

Neither of these two strategies create liquidity on the market, that is, offers more opportunities for anyone who wants to buy or sell to do so. Instead they seek to create, and/or exploit opportunities.

crdoconnor6• 9 years ago

The sheer number of market making trades provides ample cover to hide some of the less legit trades if/when regulators come a-knocking.

As you said, market making is super low profit.

HFT certainly used to be a fairly rich source of profit. Not sure if what it's like these days.

This is all probably just a coincidence.

crdoconnor6• 9 years ago

HFTs cannot see a customer’s order before it executes on an exchange. They cannot “jump in front of” an atomic order.

I'm pretty sure this is what bid stuffing was all about.

dsacco4• 9 years ago

No, quote stuffing can be used in latency arbitrage between different exchanges, but it is literally not possible to peek at an order before it arrives on at least the primary exchange of origin.

kleiba• 9 years ago

Damn, I clicked on the link thinking it would be an article on murderous calculus...

sp332• 9 years ago

Well here's the first related joke that came to mind: https://www.reddit.com/r/Jokes/comments/2o1rsw/a_calculus_jo...

Synaesthesia• 9 years ago

The scale of today’s derivatives market is almost too vast to comprehend. It’s measured in trillions of dollars. Traders, aided by the most sophisticated software money can buy, place bets — billions per second — on the future prices of every manner of stuff.

My grandpa can’t comprehend how bitcoin has “created value out of nothing” but really the finiancial world has been doing it for ages.

KaiserPro2• 9 years ago

Even earlier is the first bank.

At first they were just a safe place in which to store your valuables (basically they were goldsmiths renting out vault space)

Then someone (I think dutch) realised that most of the time people kept there cash in one place. Which meant that instead of raising money explicitly for lending, they could "double enter" the cash, which meant any deposits to the bank were lent out immediately.

AnimalMuppet• 9 years ago

I'm not an expert on such things, but I think it was earlier than the Dutch. It was the Italians, in the 1200s.

golergka• 9 years ago

In one case, "nothing" is decentiralized, secure and anonymous (not linked to real-life credentials) transactions, in another, it's risk management - but any way, it's far from "nothing".

snuxoll• 9 years ago

There are multiple types of futures and FD's, keep in mind. Options are an extremely useful tool, I just bought some AMD stock for the run up to the earnings call and sold a call with a $12 strike price for $71, it limits my gains but also limits my risk if AMD drops right back to $10 after the ER.

Commodity futures give other FD's a bad name.

qeternity• 9 years ago

I think the average Joe does not understand fully how financial markets create value through price discovery and risk transfer. These two elements allow society to more efficiently allocate resources and engage in activity, which can (and I would argue does) create tremendous value. There is also plenty of trading that is malicious or rent seeking and provides little value to society.

JackFr3• 9 years ago

the finiancial world has been doing it for ages

Well, not really.

Financial instruments like stocks and bonds are real legal claims on the real assets of an entity. They are not creating value out of nothing, they are transferring ownership rights.

Derivatives are a zero-sum game. There is no value out of nothing, the money you make is your counterparty's loss.

Seignorage is what the government does when it creates dollars (or when bitcoin is created). That truly is creating money for nothing.

tehsauce2• 9 years ago

Well, not really.
Financial instruments like stocks and bonds are real legal claims on the real assets of an entity. They are not creating value out of nothing, they are transferring ownership rights.

While an instrument making a claim to a real asset can't create value from nothing, it can create value from almost nothing. For example if the going price for a particular beanie baby is $100,000 a huge amount of speculative value has been created from a very small (basically nothing) real world value. In general it's poor speculation that causes problems, not necessarily the nature of the asset itself

gyom• 9 years ago

Here is something to consider. Assume for a moment that people use rare Pokémon cards as a form of payment, because everyone plays Pokémon. You can buy a card with Pokémon cards. But these cards aren't being printed anymore and the supply never increases.

If I issue some kind of "IOU" certificate, redeemable for a rare Charizard card, and people trade those IOUs instead of redeeming them (good thing because I don't have those Charizard cards in my possession at the moment), then I'm basically expanding the supply "things that people trade and commonly use to pay for goods" (i.e. money/currency).

I didn't create any new Charizard card, but as long as people don't ask me to redeem them, it's roughly as though the market had 10 more copies of that card circulating.

There isn't more "value/wealth" created, but there is now more "money/currency" circulating. You can imagine how something similar is happening with derivatives.

namelost2• 9 years ago

Anybody can create dollars. If you take a loan out from a bank you are creating a dollar. If you make a payment on your loan you are destroying a dollar.

usefulcat2• 9 years ago

Seignorage is what the government does when it creates dollars (or when bitcoin is created). That truly is creating money for nothing.

Institutions such as banks and credit unions are also able to create money 'from nothing', via lending.

When they make a loan, it's not as though they deduct the amount loaned (or any part of it) from someone else's account, and typically they're allowed to make loans totaling many times (9x? 11x? I forget) the amount of deposits they possess.

lodi2• 9 years ago

Derivatives are not exactly zero-sum.

a) Imagine a coin tossing game. We both put in a dollar and flip a coin; heads you win both dollars, tails I win both dollars. Truly zero sum.

b) Consider a vendor selling me a $5 hamburger for $5. They lose $5 worth of goods and gain $5 worth of cash; I lose $5 worth of cash and gain $5 worth of goods. In an accounting and physics sense this is zero sum; no dollars or molecules were created or destroyed, the universe just slightly rearranged itself. But in economic terms, this isn't a zero-sum transaction; the purchase created value since at that exact moment I valued the hamburger more than the cash (due to hunger), and the vendor valued the cash more than the hamburger. We both improved our situation and created value "for nothing". After eating the hamburger, I satiate my hunger, and now value a second hamburger less than $5, which prevents a second trade from happening for a few hours.

c) Let's say I'm a wheat-producing farmer and you're a wheat-consuming baker, and there are thousands of others like us in the economy so neither of us really has any effect on wheat prices. When the wheat price is up, I benefit, and when the wheat price is down, you benefit. At this point we have a zero sum situation. Now let's say we're both reasonably content with the wheat price being what it is right now, so we sign a "futures" agreement for me to deliver wheat to your bakery for the next year, locked in at the current price. By signing the contract, I'm choosing to forgo extraordinary profits next year if the wheat price happens to go up, but also insuring myself against extraordinary losses if the wheat price happens to go down. Your end of the bargain is the same thing in reverse.

Like the hamburger example, in an accounting sense this is zero-sum. My potential profits are exactly equal to your potential losses, and vice versa. But in an economic sense, there was another quantity that was affected in this transaction: risk. Both of us reduced our wheat price risk to zero for the next year. Risk is something people intrinsically dislike, so it has disutility (i.e. negative value). Eliminating a negative therefore adds value.

As a concrete example, let's consider what would happen if you couldn't sign the futures contract above--let's assume no modern banking or finance at all for this example--and had to just accept wheat price fluctuations. Overall, on average, the highs and lows should more or less cancel out. But on a short-term basis it's not unlikely at all to have a run of 3-5 years of bad prices (too low for me, or too high for you). To survive this potentiality, we'd both have to set aside a considerable rainy day fund just in case I had to cover 3-5 straight years of depressed profits or outright losses. Most of the time this cash will be unused, but the mere threat of a prolonged unlucky spell means we can't use that cash to buy more land or tools. The net effect on all farmers and all bakers is that everyone has a large chunk of their wealth sitting around in a completely unproductive state, which ultimately means less loaves of bread are produced and society is relatively impoverished.

Likewise, other financial derivatives like options, swaps, etc., also create economic value. They might be zero sum in a cash sense, but they affect some more-abstract quantity like "risk" or "leverage" and therefore create value for both buyer and seller.

Robotbeat• 9 years ago

That's the secret: EVERYONE can do this.

If you've written an IOU, you've created a kind of currency. Same for arcades, carnivals, etc. Any time you acquire a service or good in exchange for a promise of a service or good in the future (and that promise could also be in a tangible thing like gold, seashells, or bottles of Tide, but often it's just word of mouth), you've created a kind of currency. The real ticket comes when you can convince third parties to accept your promise and trade goods in exchange for it.

But alternative currencies have a really long history, as old as society and maybe older. They tend to arise during depressions when fiat currency is hard to come by. I don't think it's by accident that Bitcoin was first published in 2008 and released in 2009, during the Great Recession. This is liquidity being popped out of the ether due to demand for more currency (in spite of pumping by the Fed). And this is why I never really bought the "infinite" deflationary story for Bitcoin: people can just start another cryptocurrency if there's actual demand for it. Of course, that doesn't take into account irrational speculation...

The current ramp-up in cryptocurrencies is occurring now, during a relative economic boom. This is pro-cyclical and probably bad. It'll eventually pop, but no one knows when.

matt4077• 9 years ago

It's funny how people consider government intervention and centrally managed economies to be terribly inefficient, yet nonody counts the collective revenue of financial institutions as (at best) a necessary inefficiency of a market-based system. Same for advertisement, deadweight loss, artificial scarcity etc.

It's pretty obvious that free markets (with a few guardrails) work better than anything else we've tried so far. Yet there's so much overhead spent on managing the system, one wonders how anything ever gets done...

runeks2• 9 years ago

Financial institutions are not a product of the free market — they are heavily regulated by government.

On top of that, the currency that has been given legal tender status by government, and the currency used as the basis for calculating capital gains tax, just happens to be issued by the central bank that’s willing to monetize the government’s debt. What a peculiar coincidence.

mcguire• 9 years ago

Financial institutions are a product of the free market, but are heavily regulated ("heavily?") by the government because humans are congenitally incapable of failing to avoid moral hazards.

Retric• 9 years ago

Financial institutions predate government regulations. Their general role is cash flow management (ex: Loans) or risk mitigation (ex: Insurance).

lodi2• 9 years ago

...the collective revenue of financial institutions as (at best) a necessary inefficiency of a market-based system.

This doesn't make sense. If every dollar of their revenue created more than a dollars worth of value for the rest of the economy, then it's a net win. To put it in a different way, consider the economic losses if you couldn't get cheap mortgages, loans, etc. from financial institutions.

wyager• 9 years ago

The scale of today’s derivatives market is almost too vast to comprehend. It’s measured in trillions of dollars.

The commonly stated notional value of the derivatives market is sort of a nonsense number. It’s based on (very roughly speaking) the number of derivatives contracts times the value of their underlyings. This means that if you had, let’s say, a billion binary contracts that paid out one cent if Apple was above $180 in one month, this would have a notional value of like $175B, even though the maximum amount of money that changes hands is $10M and the market value of the contracts is even less than that.

I looked actual estimated market value of all derivatives contracts a while back and it was something like 1.5% of the stated notional value. It’s still really big, but iirc substantially smaller than “normal” investments like stocks and commodities. Not saying the article’s wrong, it is indeed trillions of dollars even after accounting for this. Just an interesting thing that isn’t usually mentioned.

Death by Derivatives

Related Stories