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Saturday April 19th 2014

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House of Sticks: Origin of Derivatives


One can trace the origin of derivatives, for the purpose of the future delivery of a product, to Mesopotamia circa 2000 BC. The actual trading of derivative contracts can be tracked to the Byzantine Empire circa 400 AD. Belgium and Holland eventually became trading centers, and one can find interesting stories about the collapse of tulip futures in the 1630s and the South Sea bubble economies of the 1720s.

The creation of the interest rate “swap” in the 1980s began the meteoric rise of the global over-the-counter (private) derivative markets. We experienced a serious savings and loan crisis in 1990 that also impacted some of our larger banking institutions. Congress was demanding transparency after it learned that some of our financial stalwarts held less than desirable, non-bank, assets on their books. Analysts, however, were watching an opposite trend develop in the early to mid 1990s. Some of our “money center” banks were depending more on “trading” for their revenues and profits instead of the usual commercial banking activities. That trading was done in the form of OTC “swaps”. Values of OTC derivatives surpassed the values of all exchange-traded derivatives during that same period.

Orange County, Ca. was not the only victim of the 1990s. Proctor and Gamble took a 150 million dollar hit on interest rate “swaps”. Britain’s Barings Bank had been around since the 1720s. Then came the Millennium, and what was left of Glass-Steagall was repealed. The global financial companies were off to the races to private derivatives development on interest rates, mortgages, currencies, and commodities. Long Term Capital Management and Enron, in the meantime (yes….derivatives blowouts), became highly publicized corporate failures while the country also was dealing with an overdose of dot-com fraud.

I barely have scratched the surface with my short overview. What I am hoping to accomplish with this piece is to become an instigator. Read one of the books I mentioned last week. Check out the historical articles on-line. Eventually you will start scratching your head, because some of the same names keep appearing as the alleged culprits. Stay tuned.

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