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Finding a Cure For Financial "Derivatives":
The Market Cancer
Printed in the The American Almanac, 1993
Contents
- Finding a Cure for Financial Derivatives
- Part I: What Are Derivatives
- Part II: How Derivatives Grew
- Part III: Case Studies -- Derivatives and Agricultural Commodity
Transfers - Derivatives Create Mass Global
Unemployment, by Richard Freeman, also printed in The New Federalist, September 6,
1993.
Finding a Cure for Derivatives: The
Market Cancer
Return to Top This pamphlet presents some materials related to thebackground of so-called financial derivatives, and to
jailed economist Lyndon LaRouche's proposed 0.1% sales tax
on each such transaction. For clarity's sake at the outset, the following ought
to be understood, as background to our assessments of
current and recent volume of trading in derivatives, and
the effect of the proposed tax. This, because in addition
to the revenue-raising potentials of the tax, LaRouche
also insisted that the imposition of such a tax would
contribute to bringing out-of-control, speculation-driven
markets under proper executive control. The imposition of
the tax would help reveal the problems to be encountered
in doing such a cleanup. Here are some of the problems, and thus some of what
has to be brought under control:
- The bulk of such trading, as is profiled below,
the so-called ``over-the-counter'' segment, is blatantly
illegal under present U.S. law. Under standing provisions
of the Commodity Exchange Act, it is illegal for banks, or
anyone else, to deal in futures contracts outside of
commodity exchanges. This is never mentioned publicly by
any of the partisans of derivatives. ``Over-the-counter''
derivatives are only traded safely at this time because
of the work of the former chairman of the Commodity
Futures Trading Commission, Wendy Gramm (wife of the
loud-mouthed priest of financial orthodoxy Texas Sen. Phil
Gramm), who was given the right to ``waive'' existing law. - All treatments of derivatives, generated from
within the financial and regulatory communities,
distinguish between exchange-based and ``over-the-counter''
trading between banks, as if they were completely separate
activities. The distinction is fraudulent.
``Over-the-counter'' derivatives--for example, a swap
between a floating-rate Swiss franc-denominated instrument
and a fixed-rate dollar instrument--are consummated and
put into effect through exchange-based trading of
currency, bond, and interest rate futures and options. The
degree to which the growth of the $1 trillion per day
foreign exchange market, or the $300 billion per day
market in U.S. government securities, is conditioned by
trading generated as a result of illegal inter-bank
``swaps,'' is unknown.For these reasons, it is impossible to estimate, to
any acceptable degree of accuracy, what the size of the
legal market is which would be subject to the tax. And
obviously, one would not want to legitimize what is
already outside the law, by subjecting such crimes to a
tax. - Leaving the matter of crime aside, trading
volumes, and the rate of turnover of the contracts
traded--i.e., the actual, not the notional maturity of the
instruments traded--are likewise unknown. This makes
EIR's previously relatively high estimates of the effect
of the proposed tax, and our presently relatively low
estimates, equally suspect. They should be understood as
hypothetical extremes. The more so, given the fact that
the bulk of such trading is flatly illegal. For example:- No reporting of derivative exposure by banks
includes instruments with maturities of 14 days or less;
yet the purpose of bank swap arrangements, for example, is
to transform nominal medium- and long-term maturity
instruments into short-term instruments, such that daily
trading subserves a contract which is renegotiated every
three months. - No consolidated accounting exists of activities
by bank holding companies and all their subsidiaries, or
by so-called non-bank financial companies--e.g., GE
Capital Corp. and General Motors Acceptance Corp (GMAC).
Volume estimates are based either on particular banks'
activities, or on activities of holding companies as such.
The reports for both cover different time-frames. They are
neither complete, nor are they compatible.
Non-deposit-taking lending institutions (non-bank banks in
the present parlance) are not covered at all, because they
are not regulated. Yet GE Capital and GMAC, and they are
only two, are as large as the largest of the bank banks.
- No reporting of derivative exposure by banks
derivatives market, or series of markets, is estimated at
some undetermined part of $16 trillion--the same order as
the total financial and tangible assets in the U.S.
economy as a whole, according to the Federal Reserve's
balance sheet of the U.S. economy. How could such an
immense market have come into existence in defiance of
existing law?
Investigate the Federal Reserve
To find out the truth, it would be sufficient tomount a real investigation of what the Federal Reserve has
been doing since 1978, and, specifically, what the Federal
Reserve Bank of New York has been doing. The Federal
Reserve is supposedly responsible for monetary policy, and
through its discount window operations helps set the
interest rates which govern the yields sought by the
derivatives operators. Such an investigation ought to focus on three areas:
- Narrowly, how has the Federal Reserve has interpreted
its regulatory mandate over stock index futures markets,
and how and why was the Federal Reserve given such a
mandate in the first place? - More broadly, what does the Payment and Settlement
Committee of the Federal Reserve Bank of New York actually
do, and what role does the Federal Reserve play in its
work? This committee generally brings together financial
institutions, clearing organizations, and securities
exchanges ``to facilitate communication on payment and
settlement issues,'' and coordinates with senior officials
of the Federal Reserve Bank. - What is the effect of Federal Reserve involvement
in derivative-driven markets on credit generation, the
banking system, and the economy as a whole? - What is the extent of criminal collusion between
the Federal Reserve Bank of New York and the eight
commercial banks which account for 90% of the activity in
``over-the-counter'' derivative transactions? The Federal
Reserve Bank of New York is owned by the same banks which
have systematically been violating the Commodity Exchange
Act.
straightforward:
- So long as present methods of organizing credit
flows within the economy and financial system are
continued, there will be no prospect of economic recovery,
nor a feasible job creation program, nor any capital- and
technology-intensive renewal of the economy. - Derivative markets--options, futures options,
options indexes, swaps, strips--whether on or off
exchange, given the rate of growth in their international
volume and turnover, especially in currencies and bonds,
have become key in setting financially ``acceptable'' rates
of return, thus interest rates, and thus overall credit
flows. - Bush administration policy and Alan Greenspan's
Federal Reserve commitments to avoid at all costs the
spillover of the savings and loan banking crisis into the
nation's commercial banks, by increasing spreads between
bank lending and borrowing, made the problem much worse
than it would otherwise have been. Returns from commercial
and industrial loans cannot match the derivative-enhanced
yield on the tax-free 4-5% spread they have been given in
recent years. - To organize a recovery is to create new wealth. New wealth can only be created by putting Americans back
to work in modern infrastructure construction projects,
necessary to support expansion in employment and economic
activity, and in technologically progressive capital goods
industries, to increase productivity. This increases the
tax base without increasing tax rates, and thereby reduces
the deficit. Every 1 million jobs created at
$30-40,000 per year gross will add between $5 and $6
billion to the Treasury's personal taxation revenue stream
directly, and will obviously have quite dramatic
additional indirect effects. Unfortunately, the time-frame for achieving project
viability, and the discounted present cash value of the
returns on such investments, cannot compete with the
derivative money-go-round. - Therefore, either derivatives and their users
submit to an exercise of national will, or the country
submits to the continued rule of those who employ
derivatives, in violation of its very laws.
I. What Are
Derivatives?
Return to TopThe textbook definition of a financial derivative is afinancial instrument, the value of which is based on the
value or values of one or more underlying assets or
indexes of assets. Derivatives can be based on equities
(stocks), debt (bonds, bills, and notes), currencies, and
even indexes of these various things, such as the Dow
Jones Industrial Average. Derivatives can be sold and
traded either on a regulated exchange, such as the Chicago
Board of Trade, or off the exchanges, directly between the
different counterparties, which is known as
``over-the-counter'' (OTC). The textbook explanation of
the purpose of derivatives is that they serve to reduce
the risk inherent in fluctuations of foreign exchange
rates, interest rates, and market prices. Derivatives
traded on exchanges also are said to serve as a ``price
discovery'' mechanism. According to the Bank for International Settlements'
October 1992 report, Recent Developments in International
Interbank Relations, ``swaps'' are the largest type of
derivatives, as measured by the notional prinicpal
amount outstanding (Table 1). A generation or so ago, the matter of what derivatives
are might have been adequately summarized by contrasting
the difference between investment, on the one hand, and
gambling or speculation, on the other. The instruments which ``underlie''
derivatives--stocks, bonds, commodities, money--represent
a claim, usually through ownership, on wealth produced in
the economy. Such claims can be purchased. Thus, shares in
a company can be bought, as can bonds issued by
governments or corporations, or hard commodities produced
by agriculture, forest industries, or minerals extractors
and refiners. The instrument so purchased provides a means by which
the wealth produced may be turned into money. In the case
of stock, this may take the form of the company's dividend
payment, the part of after-tax profits distributed to
shareholders, or it might take the form of capital gains
realized through the appreciation of the stock's value.
Formerly, such monetization, or potential for
monetization, would have been more or less directly
related to the economic performance of the company, in
contributing to an increasing overall rate of wealth
generation through productivity-enhancing increases in the
powers of labor. So too are bonds directly related to
economic activity, though where stocks represent equity
ownership, bonds represent indebtedness. The interest paid
corresponds, more or less, to the dividend yield of a
stock. And like stocks, bonds can provide capital
appreciation. A generation ago, such financial instruments were the
means for transforming economic surplus into monetized net
profit. ``Hard'' commodities are different, because they
are part of the materials-flow needed to sustain
production and consumption, which ought to be bought and
sold so that production might proceed--outputs of
production on the one side, are also the inputs for the
next level of productive transformation on the other:
Wheat becomes flour, flour becomes bread; iron ore becomes
steel, steel becomes machinery, buildings, automobiles,
and household appliances. Such activities used to
contribute to generation of surplus, but their
monetization is not part of after-tax profits. Purchases of stocks and bonds would once have been
seen as investment for the long haul. Trade in commodities
would have been seen not as investment, but as purchases
and sales. With what are now called derivatives, we move from
investment, and purchases and sales of hard commodities,
to speculating on the future price or yield performance of
what were once investments, and relatively simple,
economically necessary transactions. All derivatives are actually variations on futures
trading, and, much as some insist to the contrary, all
futures trading is inherently speculation or gambling.
Thus until late in 1989, all futures trading, of any sort,
was outlawed in Germany, under the country's gambling
laws. Such activities were not treated as a legitimate
part of business activity. And, who will contend against
the observation, that Germany did quite well without them? There are two types of futures trading; each can be
applied to each of the instruments, like stocks and bonds,
which, bought directly for cash, monetize what used to be
after-tax profits. The first type is, as it were, a second
step removed from economic activity as such. This is
futures trading per se: contracting to buy or sell at a
future date, at a previously negotiated price. Here the
presumption used to hold, that commodities, for example,
would actually change hands for money, as the agreed-on
contracts fell due. The other kind of futures contract, called an option,
moves another step further away from economic activity as such.
Now what is bought or sold is the right, but not the
obligation, to buy or sell a commodity, stock, bond, or
money, at a future price on an agreed-on date. Where the futures contract speculates on what the
price that would have to be paid against delivery will be,
the option simply speculates on the price. At yet another remove from economic activity per se
is an index. An index is not the right to buy a commodity or
stock in the future which is traded, but the future movement
of an index based on a basket of stocks, commodities,
bonds, or whatever.
Futures contracts
In the United States, futures contracts on corn,oats, and wheat began to be traded on an organized
exchange, the Chicago Board of Trade (CBOT), in 1859.
``Notional principal amount'' refers to the value of the
underlying assets in a futures contract. For example, in a
corn futures contract to take future delivery of 5,000
bushels three months hence, the notional principal amount
of the contract would be the price of a bushel of corn
times 5,000. If the price of corn were, for example,
$2.00, the notional principal value of the corn futures
contract would be $10,000. But the actual price of the
contract, however, is the margin set by the exchange; the
CBOT, for example, requires $270 be paid to purchase a
futures contract that on May 15 had a notional value of
$11,637.50. Since financial deregulation in the 1970s, futures
contracts have been developed for things that are not
assets or commodities. The first move was the introduction
of futures contracts on foreign exchange rates. In May
1972, the International Monetary Market of the Chicago
Mercantile Exchange (CME) began trading in the first
financial futures: futures contracts on the British pound,
Canadian dollar, German mark, Dutch guilder, Japanese yen,
Mexican peso, and Swiss franc. In October 1975, the CBOT introduced trading in the
first futures on interest rates, on the Government
National Mortgage Association's (GNMA) mortgage-backed
certificates. In January 1976, the CME began futures
trading in 90-day U.S. Treasury Bills. Trading in futures
contracts on 15-year U.S. Treasury Bonds began on the CBOT
in August 1977. Trading in such interest rate futures, as
they are called, quickly grew to become the most heavily
traded futures contracts in the world. On the CBOT,
trading in Treasury bond futures and options has risen
from 28.3% of total volume in 1981, to 64.4% of total
volume in 1991. In February 1982, futures contracts for indexes of
asset values began trading, with the introduction of
futures contracts based on the Value Line Average Stock
Index, on the Kansas City Board of Trade. Two months
later, the CME began trading in the Standard and Poor's 500
Stock Price Index, which is now one of the most heavily
traded futures contracts at the CME. Trading in this
contract is considered so important, that the CME set up
a special room in a different building to allow continued
trading in the S&P 500, when the CME was forced out of its
building by the flooding waters of the Chicago River in
May 1992, closing trading in all other futures contracts.
Not coincidentally, the S&P 500 Stock Price Index futures
contracts is one of the instruments the U.S. Federal
Reserve has reportedly used since October 1987 to reverse
collapses on the New York Stock Exchange.
Oher Derivatives
There are other types of derivatives which are nottraded on exchanges but are negotiated between contracting
parties, usually large banks. These are called
``over-the-counter'' instruments. ``Swaps'' are designed to
transform a nominally long or medium-term contract into a
succession of shorter-term maturities. For example, swapping a floating rate Swiss
franc-denominated obligation for a fixed-rate dollar
instrument between banks, involves the Euromarket, the
currency markets, the swap market, and perhaps also the
interest rate futures and/or options markets. The intrepid
might want to try to calculate how far we now have moved
from the first level of cash purchases of stocks and
bonds. An interest rate swap is a transaction in which two
counterparties agree to exchange two different types of
interest payment streams based on an underlying notional
principal amount. For example, assume that a bank with a
portfolio full of adjustable rate mortgages (ARMs) wished
to receive an income stream of fixed-rate interest
payments. The bank would package together, say, $10
million of such mortgages, all paying interest currently
at 6.5%, and exchange the ownership of the interest
payment stream from that package of ARMs with a
corporation that would give the bank in return the
ownership of an interest payment stream fixed at, say, 8%.
The notional principal amount of the swap would be $10
million, but the actual amount of money that exchanges
hands would be limited to the interest payments each
counterparty owed to the other over the life of the swap. Swapping of interest rates is said to have begun in
connection with the Eurobond market in the early 1980s,
when high interest rates dictated that only the highest
quality borrowers could qualify for long-term, fixed-rate
financing. Borrowers of lesser quality, who were excluded
from such financing, were able to obtain it indirectly
through swaps. However it was not until the U.S. Student Loan
Marketing Association (Sallie Mae), began using swaps in
1982, that they began to be widespread. Sallie Mae was
seeking a way to avoid having to borrow longer-term,
higher-priced funds, to lend out for shorter terms at
lower rates. The swaps used by borrowers in the Eurobond
markets proved to be the perfect vehicle for Sallie Mae,
which, as a quasi-government agency, is perceived by the
markets to be an extremely high-grade borrower. The first
swap for Sallie Mae was arranged through an investment
bank in the summer of 1982, with ITT as a counterparty.
ITT reportedly saved 17 basis points (17@nd100 of 1%) in
borrowing costs in the deal.
Currency Swaps
Currency swaps have been used by central banks fordecades. The Bank of England, for example, would receive a
set amount of dollars from the U.S. Federal Reserve in
exchange for a set amount of pounds, in order to have
dollars to use on the foreign exchange markets. After a
period of time, the Bank of England would return the
dollars to the U.S. Federal Reserve, and receive back its
pounds. The accepted definition of a currency swap is a
transaction in which one counterparty exchanges its
principal and cash flows denominated in one currency, for
the differently denominated principal and cash flows of
another counterparty. At an agreed upon future date, the
two counterparties close out the transaction by reversing
the swap of the principal. In the 1970s, a small number of currency swaps were
arranged that were not related to central bank activity. A
U.S. dollar/French franc swap, for example, was arranged
for the Republic of Venezuela to help meet payment
obligations arising from the construction of a commuter
rail system in Caracas. The details of these swaps were
largely kept from the public view, for fear of disclosing
proprietary operating information. After the debt bomb exploded when Mexico threatened a
debt moratorium in 1981, however, the World Bank widely
publicized a swap arranged by Salomon Brothers between
itself and IBM. The motivations of the World Bank and IBM
to conclude the transaction made the swap exceptional at
the time. The World Bank was seeking to maximize the rate
of interest on its debt, and IBM was seeking to hedge its
Swiss franc and German mark debt, while at the same time
capturing a paper profit from the appreciation of the
dollar against both currencies. As Michael Wood, senior
manager of International Financial Markets at Dresdner
Bank in Frankfurt, noted in the 1992 textbook Cross
Currency Swaps, by Lehigh University professor Carl
Beidleman, it was ``the first time that a currency swap
was used to arbitrage between capital markets, that is,
where a capital market issue was done solely for the
purpose of swapping into another currency.'' And then there are caps, floors, and collars, options
on the anticipated interest rate movements which make up
the swap:
- Caps, in which the buyer will receive from the seller
the difference between current interest rates, and some
agreed-upon rate, in the event interest rates move above
the agreed upon rate. In return for thus limiting its
exposure to interest rate increases, the buyer pays to the
seller a onetime fee. - Floors, in which the buyer is protecting himself from
decreases in interest rates. That is, if interest rates
fall below an agreed-upon level, the seller is obligated
to make up the difference to the buyer, in exchange for
the up-front fee paid by the buyer. - Collars, in which the buyer of a cap simultaneously
sells a floor at the same time, or vice versa, with the
object of maintaining interest rates within some defined
band. - Currency forwards are perhaps the simplest
derivative instruments, and perhaps the one with the
greatest utility for companies involved in producing and
shipping goods in foreign trade, given the insanity of
floating exchange rates. Assume that Boeing has sold an
airliner to Lufthansa. Rather than go through the trouble
of converting the deutschemarks paid by Lufthansa into
dollars--and being subjected to the risk of changing
exchange rates if Lufthansa is paying Boeing back over a
period of time--Boeing pays a fee to an intermediary (a
swap dealer) to find a German company that has sold
something in the United States that is of comparable value
to the Boeing airliner purchased by Lufthansa. Let us
assume that Siemens has sold some power-generating
equipment to a U.S. utility. Under a currency forward, the
utility that had bought equipment from Siemens, will pay
dollars to Boeing instead of Siemens, and Lufthansa will
pay deutschemarks to Siemens instead of Boeing. In other
words, Boeing gets Siemens's U.S. income stream in the
United States, in exchange for which Siemens gets Boeing's
deutschemark income stream in Germany.Thus, the definition of a currency forward is a
contract in which two counterparties agree to exchange
differently denominated income streams at an agreed upon
exchange rate at some point in the future. There is no
swapping of principal involved.
``over-the-counter market'' is quite illegal, since by the
current version of the Commodity Exchange Act, banks and
related agencies are prohibited from engaging in
off-exchange futures contracts. Thanks to Sen. Phil
Gramm's wife Wendy, former head of the Commodity Futures
Trading Commission, regulatory agencies have successively
undermined that exclusion through so-called interpretation
and exemption, just as the earlier prohibition of options
was undermined, or just as the 1930s Glass-Steagall Act,
which divided U.S. banks into two, mutually exclusive
types--commercial banks and investment banks--is now being
disregarded, even though it remains on the books.
II. How
Derivatives Grew
Return to TopAccording to the October 1992 report of the Bank forInternational Settlements, Recent Developments in
International Interbank Relations, ``since the mid-1980s,
the growth of turnover and of volumes outstanding in
markets for derivatives instruments, including
over-the-counter (OTC) markets that offer more customized
products, has outpaced the growth of most other financial
activity.'' As seen in Figure 1, by 1988, the ``notional
principal amount'' (referring to the value of underlying
assets) of derivatives outstanding had exceeded
the total market capitalization of the New York Stock
Exchange. By 1989, the notional value of derivatives
outstanding was almost one-third larger than the total
market value of all publicly listed companies in the
United States. By the end of 1991, the notional value of
derivatives was soaring toward being double the market
capitalization of all U.S. publicly listed companies. In other words, if the phenomenal growth rate
derivatives exhibited from 1986 to 1991 has continued in
the past two years, the amount of derivative paper
outstanding--none of which is carried on corporate
balance sheets--is now somewhere around twice the total
market value of all publicly listed companies in the
United States. That financial derivatives have grown to such an
extent is all the more amazing, considering that these
instruments simply did not exist 25 years ago. The largest
single type of derivatives, interest rate swaps, did not
get off the ground until the summer of 1982. Futures on
currencies did not come into use until May 1972. Interest
rate futures first came into being in October 1975. Oddly enough, there are no official figures available
for the dollar volume of futures trading in the United
States. Not even the Commodities Futures Trading
Commission, the federal government agency charged with
regulating the futures markets, has figures for the dollar
volume of futures trading. Neither do the Chicago Board of
Trade or the Chicago Mercantile Exchange, the two largest
futures exchanges. The only figures available are for the
number of contracts traded (Figure 2). By multiplying the number of contracts traded of a
certain basic type--agricuultural commodities, precious
metals, energy products, currencies, and financial
products--by an average price for each basic type, EIR has estimated that the U.S. futures markets have an annual
turnover of around $25 trillion. This is a major revision
from EIR's original estimate of $152 trillion, published
in December 1992. Still, it demonstrates that the futures
markets dwarf the New York Stock Exchange, which had a
market capitalization of $3.713 trillion, and total value
of shares traded of $1.520 trillion in 1991. The futures markets are also some five times larger
than the U.S. Gross National Product, which was $5.519
trillion in 1991. These gigantic markets are highly concentrated, with
a mere handful of firms completely dominant. A report by
the Board of Governors of the Federal Reserve System, the
Federal Deposit Insurance Corp., and Office of the
Comptroller of the Currency, Derivative Product
Activities of Commercial Banks, issued on Jan. 27, 1993,
revealed that the ten largest commercial banks in the U.S.
control 95.2% of all derivatives activities by U.S.
commercial banks (Figure 3). The same situation probably exists on the investment
bank side. In a listing of the 40 largest institutions in
the futures markets, ranked by customer equity (the
futures markets define equity as the residual dollar value
of a futures account, assuming it were liquidated at
prevailing market prices), in the March 1993 issue of
Futures magazine, the five largest were investment
banks: 1) Merrill Lynch Futures, Inc. ($2,176.9 million);
2) Goldman Sachs and Co. ($1,581.3 million); 3) Shearson
Lehman Brothers, Inc. ($1,527.7 million); 4) Dean Witter
Reynolds, Inc. ($1,120.1 million); and 5) Prudential
Securities, Inc. ($1,106.1 million). These were followed by 6) Refco, Inc. ($1,071.3
million); 7) Morgan Stanley and Co. ($844.7 million); 8)
Cargill Investors Service, Inc. ($804.5 million); 9) Daiwa
Securities America, Inc. ($588.5 million); 10) PaineWebber
Inc. ($576.2 million); 11) Bear Stearns Securities Corp.
($539.4 million); and 12) Salomon Brothers, Inc. ($488.6
million). Of these firms, the three with the largest net
adjusted capital (the amount of liquid capital established
by Commodities Futures Trading Commission capital
requirements) were Salomon Brothers ($999.6 million),
Goldman Sachs ($963.6 million), and Shearson Lehman
($859.4 million). EIR's revision of its estimate of the size of the
futures markets means that the largest market in the world
remains the foreign exchange, or currency, markets. In
March, the Bank for International Settlements (BIS) issued
a new report, Central Bank Survey of Foreign Exchange
Market Activity in April 1992, which states that foreign
exchange trading increased 42% from 1989 to 1992, to an
estimated $880 billion per business day. This figure
includes derivatives trading in currencies (i.e., futures
contracts on currencies, swaps, and options), but also
excludes offsetting positions. The actual total gross
turnover reported by the 26 central banks which conducted
the surveys, was $1.354 trillion a day. According to the BIS report, London now trades more
dollars and deutschemarks than the United States or
Germany does. London has increased its share of world
trading, from 25% or $187 billion in 1989, to over
40% or $300 billion in 1992. Trading in London is also
increasingly concentrated, with the 10 most active banks
in the City of London accounting for 43% of trading in 1991,
compared to 36% in 1986, according to a report issued last
year by the Bank of England. That means 10 London banks
accounted for 18% of all world currency trading in April
1992 (Figure 4). The second largest currency market was the United
States, reporting a daily volume of $129 billion in 1989,
and $192 billion in 1993. Japan was the third largest,
with daily volume in April 1989 of $115 billion, and $126
billion in 1993. The fifth and sixth largest markets were two key
members of the British Commonwealth: Singapore and Hong
Kong, with $76 billion and $61 billion in daily trading in
April 1992, respectively. If the figures for Britain,
Singapore, and Hong Kong are added together, it will be
seen that the British Empire controlled almost exactly half
of the $880 billion in foreign exchange trading that took
place every day in April 1992. In December 1992, for the occasion of the meeting of
the finance and bank ministers of the Group of Seven, the
BIS issued a new estimate of daily world currency trading,
of $1 trillion a day.
III. Two Case
Studies
Derivatives and Agricultural Commodity Trading
Return to TopHow much does the trading activity on the futuresmarkets contribute to ``making the economy more
efficient?'' Just how many grain futures
contracts--covering corn, wheat, oats, soybeans, barley,
and sorghum--that are traded on the futures markets, are
real, representing the movement of agricultural produce,
and how many are purely speculative trades? Most American farmers will tell you that the
agricultural futures markets, whether for grain, livestock
products, oilseed products, orange juice, coffee, or
sugar, are the farmers' worst opponents, forcing the price
of grain products down below production cost. Only 5-15%
of farmers even bother to use the futures market to sell
their products. Normally, in theory, the agricultural futures market
would work in the following way. A wheat farmer, at
planting time in the spring, might see that the price of
wheat is but $2.25 per bushel. He might buy a September or
December wheat futures contract (a ``put'') that will pay
him $2.75 for his wheat at the month at which the contract
expires. This way the farmer has guaranteed himself a
minimum price for his wheat when it comes time to sell. However, most farmers know that the theory does not
work out that way in practice. The eighth largest futures
trading firm in America, for futures trading of all kinds,
is Cargill Investor Services, Inc., run by the Cargill
grain cartel. The 34th largest futures trading firm is ADM
Investor Services, Inc., of Archer Daniels Midland. They
directly manipulate prices against the farmer. Consulting the statistics provided by the Commodity
Futures Trading Commission, which regulates the futures
and options industry, in 1992, there were 17,552,356 grain
futures contracts traded. Of that total, only 64,200 were
settled by delivery/cash settlement, meaning that the
actual grain produce of the contract was taken for
physical delivery. That is but 0.36% of all contracts
traded. However, at the level of the farmer selling his grain
to an elevator, for each sale of real grain--called a
hedge--there has to be an offsetting speculative trade to
make the market. So, on that first level, there are
128,400 legitimate trades. Then, the local elevator
usually sells the grain to the sub-terminal or terminal,
such as in Omaha, Nebraska or Kansas City, Missouri, and
sale by the local elevator operator must be offset by a
speculative sale. Plus, the sub-terminal or terminal might
have to sell the grain one more time. So, there are three
times 128,400 contracts which can be considered
legitimate. That is 2.2% of all trades; so 97.8% of all
trades are purely speculative, having no connection to the
real process involving the farmer and his produce. They
involve speculators, often linked to the grain cartels,
moving paper back and forth, attempting to capture
spreads, or drive down the grain price for farmers.
The Bank of New England
blowout
The January 1991, failure of the Bank of New England(BNE), which had until its collapse been one of the 10
largest bank holding companies in the United States,
provides a good example of the way federal regulators have
propped up the banking system, and of the risks faced by
banks which play in the world derivatives markets. The collapse of the speculative real estate market,
which virtually wiped out the Texas banking system in the
late 1980s, spread to New England by the end of the
decade, bringing to a close the speculative bubble known
as the ``Massachusetts miracle.'' Boston-based BNE, which
had lent heavily in the regional real estate market,
suddenly found itself with overwhelming losses on its real
estate portfolio. The bank, which had grown rapidly thanks
to the real estate bubble, was dying with the collapse of
that bubble. In October 1989, BNE, which then had $31.4 billion
in assets, announced plans to dramatically downsize the
bank through massive asset sales and employee cutbacks.
The plans included selling some 10% of its branches,
closing loan production offices in Chicago, New York, and
Philadelphia, and reducing its work force by more than
20%. In late December 1989, BNE took the extraordinary
step of rescinding a previously announced 34@ct quarterly
stockholder dividend. The step was forced by federal
regulators, who were already making preparations for the
inevitable failure of the insolvent bank. Federal
regulators also threw out the chairman of the bank, and
replaced him with an interim chairman, H. Ridgely Bullock. In early February 1990, in an attempt to calm public
fears and prevent depositor runs, Bullock declared that
the bank was ``off the critical list and getting better....
We're in a fix-it mode. We're not going to be as big, but
we're going to be better.'' BNE was not ``off the critical list,'' however; the
only thing keeping its doors open was a massive covert
bailout from the Federal Reserve. By the time Bullock made
his statement, the bank had already received nearly $1
billion from the Fed. Beginning in mid-January, the Fed had begun pumping
vast amounts of money into BNE via loans from the Boston
Federal Reserve. Federal Reserve statistics show that the
Boston Fed lent banks in its region $478 million the week
ended Jan. 24, compared to just $3 million the week
before. While the Fed does not reveal to which banks the
money was lent, it is clear that most, if not virtually
all, went to prop up BNE. The weekly bank lending by the Boston Fed rose
dramatically in the following weeks: $440 million the week
ended Jan. 31, then $723 million the next week, then $930
million, and $1,280 million the week ended Feb. 21. During
each of the next seven weeks, the Fed pumped between $1.5
billion and $1.85 billion into the bank; by April 11, the
Boston Fed had lent $15.6 billion to its regional banks,
the vast majority going to the Bank of New England. By March, after some $5 billion of bailout funds had
already been injected into the bank, the Office of the
Comptroller of the Currency and the Fed issued formal
cease-and-desist orders to the bank. The Fed order
stipulated that the bank could not pay stock dividends
without permission from the Fed--a requirement that had
already been in effect for more than three months! Even more comical was the bank's admission in its
second quarter 1990 report to the Securities and Exchange
Commission, that it may need government assistance to
survive. This, after some $18 billion had already been
funnelled into the bankrupt bank! The end for the Bank of New England came on Jan. 4,
1991, when Chairman Lawrence Fish told federal regulators
that the $450 million loss the bank suffered in the fourth
quarter of 1990, had wiped out its $225 million in equity,
making the bank officially insolvent. At this point, the
bank had just $23 billion in assets, and had fallen from
10th place on the list of largest U.S. banks, to 33rd
place. Not surprisingly, the announcement triggered massive
depositor runs at the banks, with long lines forming at
its corporate offices. Two days later, on Sunday, Jan. 6,
1991, federal regulators officially closed the bank.
Federal Deposit Insurance Corp. Chairman William Seidman
estimated the ultimate cost to the agency of the failures
at $2.3 billion, at the time the second most costly bank
failure in U.S. history, after the 1988 failure of First
RepublicBank Corp. of Dallas. Why did federal regulators pump more than $18 billion
into the Bank of New England, and then close it? If they
were going to close it anyway, why did the regulators keep
the bank open for a year after it was insolvent? The answer is: derivatives. The Wall Street Journal, in a June 18, 1991,
article by Craig Torres, revealed that regulators had
propped the bank up for a year in order to unwind its
portfolio of ``off-balance sheet'' derivatives transactions. ``Everybody knew we had $30 billion in assets'' on the
balance sheet, BNE head of treasury operations Arthur
Meehan told the Journal. ``But nobody but a small cadre
of regulators and analysts knew we hand $36 billion in
off-balance sheet activity.'' During November and December 1989, before BNE publicly
revealed the size of its fourth-quarter losses, BNE chief
currency and derivatives trader David Pettit was able to
trim his off-balance sheet exposure by $6 billion; getting
rid of the remaining $30 billion was not so easy. The bank, under the close supervision of federal bank
regulators, began attempting in January to cash out
thousands of derivative transactions. However, as word of
its financial troubles spread in financial circles, banks
all over the world denied BNE credit, and demanded cash up
front. Not surprisingly, this is when the Boston Fed began
pumping money into BNE. Having become a pariah on world financial markets,
BNE enlisted the help of Shearson Lehman and Prudential
Securities to help it unwind its currency swaps on the
Chicago Mercantile Exchange's International Monetary
Market. By doing so, Meehan acknowledged, ``we moved the
risk out of the interbank system into the exchanges;'' but
had we not, he said, regulators would have been forced to
take over BNE's trading positions. By the end of 1990, BNE had reduced its derivatives
portfolio to $6.7 billion. A week later, the bank was
closed. The collapse of the BNE nearly sent the global
banking system into ``gridlock,'' the Journal warned,
adding, ``It all sounds far-fetched. But that's just what
nearly happened, federal regulators say, in the months
before they seized the Bank of New England.'' If BNE, with its $36 billion in derivatives, nearly
sent the global banking system into gridlock, imagine what
would happen were Citicorp, with its $1.4 trillion in
derivatives, to fail. ``For certain banks there is a lot of exposure'' in the
derivatives market, a senior examiner at the Office of the
Comptroller of the Currency told reporter Torres. ``If we
had a real problem with one of the larger banks, a
meltdown scenario would be a possibility.'' That meltdown scenario is not just a possibility. It
is, in fact, well under way.
The History of the Fight Against
Derivatives
The fight to institute Lyndon LaRouche's proposal for aone-tenth of 1% tax on financial derivatives comes after
intense warfare over this issue by many nations that were
fighting to preserve their national sovereignty. In the
United States, trading in options on agricultural
commodities had been banned in 1936, and the ban was not
officially lifted until 1983. Farmers had opposed the highly destructive effect of
options, one of the earliest forms of the derivative market,
starting in the 1920s, long before they became as large as
they are today; even then, farmers still exercised
significant influence within the United States. In 1933, an
attempt was made to manipulate the wheat futures market
using options, which resulted in an opportunity for farmers
to force the U.S. government to ban trading in these
options. There were attempts to re-introduce trading in
agricultural options during the 1970s, but the plan met with
only limited success. It was only in January 1983, when President Ronald
Reagan signed the 1982 Futures Trading Act, that the ban was
officially lifted. This was a major feature in the
disastrous Reagan-era deregulation of the U.S. economy. America had, for a short time, a small financial
transaction tax, and the fight to impose a larger financial
transaction tax was very intense in the late 1980s.
Throughout the 1950s and early 1960s, the United States had
a low-rate transaction tax--called a stamp tax--on the
issuance and transfer of stocks and debt. The tax was
repealed in 1965.
Rumblings from Congress
However, in the late 1980s, the fight broke out moreintensely for a transaction tax of a greater size. In 1987,
Speaker of the House Jim Wright of Texas called for a
transaction tax on the financial markets. Wright's proposal
called for a 0.5% tax on both the seller and the buyer in
the same transaction, thus, effectively, amounting 1%. For
six months, there was a heated public debate over Wright's
proposal. Wright was soon driven from office in what is
generally agreed to be an overblown scandal. The Oct. 16-19,
1987 stock market crash confirmed Wright's warnings of the
instability of the financial markets. Also in the 1989-90 period, during discussion of the
1990 Budget Reconciliation Act, Sen. Lloyd Bentsen, then
chairman of the Senate Finance Committee and now secretary
of the treasury, raised a proposal for a transaction tax on
selected financial instruments on the floor of the Senate. In February 1990, partly in response to the furor over
this issue, the Congressional Budget Office, in its report
``Reducing the Deficit: Spending and Revenue Options,'' had
a section on pages 388-89, entitled ``Impose a 0.5% Tax on
the Transfer of Securities.'' Its analysis of the tax
reported that ``the tax would have to be broad-based,
applying to stocks, debt, options and trades by Americans on
foreign exchanges.'' In June 1993, Rep. Henry Gonzalez (D-Tex.) proposed an
investigation of derivatives high roller George Soros, and
the derivatives phenomenon. Derivatives, Gonzalez told the
House on June 10, is ``a fancy name for a ... contract in
which two parties agree that they will bet on the future
value of some market activity--futures--all the way from
some commodity, to such things as the currency futures which
are volatile ... Is there money out there in these
international markets for the procurement of goods, for
firing the engines of manufacturing and production? No. It
is paper chasing paper.''
What Other Nations Have Done
Various nations have taken action to tax and/or bansome of the instruments traded in the financial derivatives
market, in an attempt to assert sovereign control over their
national credit and finances.
- In 1986, the government of Sweden doubled its
equity transaction tax, which is the tax on trade of stocks
on the Swedish stock market. In 1989, Sweden extended the
tax to futures and options trades. The effect of this new
tax was to substantially reduce the trading of futures on
Sweden's Stockholm market. Furthermore, the tax closed the
Swedish Option and Future Exchange (SOFE) for two years. But
in 1990, apparently under pressure from financiers, Sweden
abolished the derivative tax, and trading in the derivatives
market exploded, helping to deepen Sweden's financial
problems. - Until as late as 1989, the German government held
firm and refused to legalize the trading of some financial
derivatives within the country. As a result of pressure from
the trading of German government bond futures in the London
markets, amendments to Germany's gambling law in 1989 made
changes and permitted retail participation in derivative
markets, followed by the opening of Germany's first
financial exchange, Deutsche Terminbo@aurse in 1990. - At present, derivative taxes are assessed in
Finland, France, Hong Kong, and Japan, although, on the
whole, they are not very large. The exception is France,
which assesses a significant 2% transaction fee. So far,
however, the fee is only used to finance the annual budget
for CMT, the French regulatory body for the futures and
options markets. Once the CMT's budget requirement is met,
the fee is no longer levied.--Richard Freeman
Derivatives
Create Mass Global Unemployment
Return to Top Unemployment, which was already at high levels globallythroughout the 1970s and 1980s, has exploded within the past
six years, the very time that the derivatives market has
risen within the United States from a few trillion to
currently $12 trillion outstanding, with a yearly trading
volume of greater than $125 trillion. The derivatives market
is the leading edge of the global financial bubble, which
has caused mass unemployment and underemployment of between
one-half and three-quarters of a billion people around the
globe. About 55 million are unemployed in the advanced
sector, and above 500 million in the developing sector. In the U.S.A., the official unemployment rate was 4.4
percent in the decade of the 1950s, 4.7 percent in the
decade of the 1960s and 7 percent today. In the 12 nations
that make up the European Community, the effect is even more
dramatic; unemployment has risen from an official rate of
2.0 percent in 1965 to 11.8 percent today. If one adds the
officially reported unemployment levels for the European
Community of 12 nations to the levels of unemployed in
Canada, Japan, and the United States, then the total level
of unemployment in the West, with the addition of Japan, is
a staggering 29 million people. But even that enormous
official number is an understatement: The unofficial, real
unemployment level is somewhere between 50 and 55 million.
This represents a criminal waste of resources. The European
Community reports that just a shade under one-half of the 17
million officially reported unemployed European workers have
been out of work for one year or more. Terrified that they cannot think of how to put their
own people back to work, at least two countries, France
and the United States, have in the last month initiated
discussion of immigration restriction laws. As the table shows, in every nation but Japan,
unemployment has skyrocketed since 1989. To some nations
with a large labor force, Canada's officially reported level
of unemployment of 1.6 million may not seem much; but
consider that against Canada's working population of 13.9
million, this represents 11.4 percent of its work force. Six
European Community members have an officially posted rate of
greater than 10 percent. They are: Britain, 10.5 percent;
Italy, 13.6 percent; France, 10.9 percent; Spain, 21
percent; Ireland 19 percent; and Denmark, 11.5 percent. The most worrisome part of the explosion in
unemployment since 1989 is the layoff of manufacturing
workers. In 1989, the United States had 19.39 million
manufacturing workers; today it has 17.82 million, a loss
of 1.56 million. In 1989, according to the British
Information Office, Britain had 5.1 million manufacturing
workers. In January 1993, it had only 4.1 million--a loss
of one-fifth in four years. Britain is truly the junk-heap
of Europe. In the western portion of Germany, between 1989
and the present the number of manufacturing jobs declined
from 7.203 million to 6.977 million, a loss of nearly a
quarter million. An estimated 1 million manufacturing jobs
may have been lost in the former East Germany during this
same time frame. And these are only the official figures. The United
States, for example, reports 8.858 million unemployed,
representing 6.9 percent of the labor force. But if one adds
in 6.580 million workers who work part-time for economic
reasons, and 6.378 million workers who are ``not in the
labor force,'' but who answer government surveys saying that
``they want a job,'' the total number of unemployed and
underemployed is 21.816 million. For a labor force of 128.3
million, that is 17.0 percent, not the official U.S.
government figure of 6.9 percent. If the real unemployed in the other nations under
consideration are brought to light, the total unemployed
in the West, with Japan, is between 50 and 55 million.
Unemployment in East Bloc and
Developing Sector
The reader should recall that derivatives trading andIMF conditionalities operate in tandem and are just two
sides of the same coin. Leading derivatives speculator,
George Soros has helped implement the IMF's shock therapy
program, especially in former Yugoslavia, throughout the
former East bloc. Take the case of Poland, where IMF conditionalities and the speculative/derivatives market are raging at the same time. Just a few years ago, in this nation of 39 million people, with a labor force of 20 million, unemployment was less than half a million, though some of the jobs