The Story On Derivatives

Jun 07 2008

Published by Roland Manarin at 11:48 am under Derivatives, Financial Safety, Ownership

A question I often get is, “What, in your opinion, is the biggest threat to the global financial markets?”

The mainstream media never touches on this but I believe that financial derivatives are the biggest threat. These highly speculative instruments, most often used by big money center banks, are what I think would most likely trigger the collapse of the world’s debt structure.

Here’s the story.

A derivative is simply a man-made bet consisting of two parties. Party A enters the bet in hopes of earning massive profits but in order to create the derivative, they need a counter party to wager against them. This is where Party B comes in. They enter the bet looking to hedge against some form of risk.

Say you are a derivative trader. You can speculate (or hedge against) the movement of interest rates, commodity prices, exchange rates, or just about anything else you wish to gamble on.

Those who participate in this global casino are required to place only a fraction of their bet down thus enabling derivative traders to control an enormous amount of assets using a tiny amount of money. This is where the danger comes in.

While traders can make big bucks being on the right side of the bet, there is also the risk of crushing losses.

This is what happened recently when a rogue trader for the second-largest bank in France made a bad bet totaling over $7 billion in losses, the largest in banking history.

But despite instances like these, the monstrous growth of derivatives continues.

Over 20 years ago, with derivatives trading around $1 trillion on a daily basis, I upped the gold hedge position in our portfolios to offer additional safety. That decision protected us during the huge stock market crash of 1987 brought on by derivatives.

Today, on the same daily basis, derivatives are trading at $500 trillion. To put that number in perspective, the U.S. has an annual GDP of $14 trillion. That means a 3 percent decline in the derivatives market would be greater than the total annual economic output of the world’s richest nation. Scary stuff.

If the derivative dike ever breaks, a panic would sweep the financial world. Bonds, money market accounts, bank CDs, cash, and all other dollar-based assets would plummet in value instantaneously.

History tells you that in these cases gold, common stock, and other tangible assets not linked to paper money become a source of value for investors. Derivatives alone are reason enough to keep a small portion of your wealth in gold-related assets.

For the remainder of your serious money, globally and geopolitically diversify it across ownership positions for maximum safety.

How large the derivative mess will grow to before the bottom falls out is anyone’s guess.

I predict we’ll continue muddling through just as we always have but just in case this house of cards one day comes crashing down, I know my investments will be safe when the dust settles.

That’s what I call peace of mind - and real world financial safety.