Last week, I penned my first article on “derivatives”. My observations and conclusions were unsettling, but flowed from a definition in Wikipedia that struck me as amazing:
“Derivative: A financial instrument which derives its value from the value of underlying entities such as an asset, index, or interest rate—It has no intrinsic value in itself.”The reason a financial instrument is called a “derivative” is that it “derives” its perceived value from some other source. The reason a derivative’s perceived value is “derived” from some other source is that the derivative is, by definition, intrinsically worthless.
If a financial instrument had intrinsic value, it could not be a derivative. On the other hand, if a financial instrument is a “derivative” its apparent value is only “derived” from some other source and that derivative is and must be intrinsically worthless.
Over the past several years, the world’s total sum of officially-recognized derivatives has ranged from $700 trillion to $1.4 quadrillion—and yet, all of those derivatives are, by definition, intrinsically worthless.
We live in a world where there there are financial instruments with an apparent value of over $1 quadrillion that are nevertheless known to be intrinsically worthless.
The mind gapes.
According to Wikipedia,
“Derivative transactions include a variety of financial contracts, including structured debt obligations and deposits, swaps, futures, options, caps, floors, collars, forwards, and various combinations of these.”
For some, that description is comforting since most of the varieties of derivatives seem remote from our daily lives and we therefore need not study the concept of derivatives too deeply. Derivatives appear to be limited to fairly exotic transactions that are too removed from most people’s lives to be deemed as particularly relevant. Because the nature and complexity of derivatives seem so confusing, most people are discouraged from studying the subject.
Derivatives are presumed to be somewhat like astrophysics—an important science for astronauts, but largely irrelevant for 99.99% of the world who will never go into space.
Not Rocket Science
In fact, the fundamentals of derivatives aren’t so hard to understand.
In fact, I begin to see that derivatives are so omnipresent, that the financial world (especially those who make, sell and profit from derivatives) don’t want the world to understand that virtually all of our perceived , paper wealth is “derivative”. The Powers That Be don’t want us to understand the extent and fundamentally simple nature of derivatives because, if we did, we’d realize that virtually all of our paper wealth is derivative.
To understand that virtually all of our modern wealth is “derivative” is to understand that virtually all of our modern wealth is “intrinsically worthless”. The cash in your wallet, the retirement account that gives you pride, most of your investments, your credit cards, debit cards, checking accounts and savings accounts; and most of your equity are all derivatives and therefore, by definition, “intrinsically worthless”.
Most of us have spent our lives working, slaving, fearing and fighting to pursue measures of wealth that are derivatives and therefore intrinsically worthless.
Would you have worked so hard if you’d known all along that most of your accumulated wealth was no more intrinsically valuable than Monopoly “money”? Would you have been so tempted to lie, deceive or exploit if you’d known all along that the “money” you were fighting for was intrinsically worthless?
The seemingly confused and incomprehensible nature of derivatives isn’t accidental. Those who make, sell and profit from derivatives don’t want you to understand that your derivatives—stocks, bonds, cash, etc.—are intrinsically worthless. If you understood, you wouldn’t value your derivatives, you wouldn’t want them, you wouldn’t buy them. And therefore those who profit from our investing in derivatives would be out of work and having to make do without two or three corporate jets.
Without our unwitting confidence in derivatives, those who control us by teaching us to lust for derivatives would lose their power and capacity to rule us.
If we were wise enough to grasp that all derivatives are intrinsically worthless, and if we were wise enough to see that virtually all of our wealth is derivative and therefore illusory, would the bankers of the world lose their capacity to control us? If we had enough sense to reject that which is “intrinsically worthless” and pursue only that wealth that had intrinsic value—could we regain our former freedoms?
However, so long as the “intrinsically worthless” nature of derivatives remains obscure and and even unbelievable, we can be easily induced to spend our lives pursuing things that are known and designed to be intrinsically worthless.
You can’t grasp this concept without feeling shocked. All of our lives, we’ve been hoodwinked by derivatives.
For me, a fundamental understanding of derivatives is found by simply rewording the definition previously seen in Wikipedia. Once the definition is rewritten, it’s easier to see that derivatives are omnipresent and far more relevant than most people imagine.
My definition of derivative is:
“Any financial instrument that has a perceived value, but no intrinsic value.”
I haven’t really changed the Wikipedia definition; I’ve just expressed it differently.
I’m simply saying that, first, every “financial instrument” has some perceived value.
Second, I’m saying that if a financial instrument is seen to have no intrinsic value, it must be a derivative.
If you’ll apply my definition for a while, you’ll see that virtually all paper or digital financial instruments are derivatives. If so, virtually all modern financial instruments are, by definition, intrinsically worthless.
Again, the mind gapes.
All Paper Debt-Instruments Are Derivatives
All forms of paper wealth are “derivative”. All you have to do is objectively examine any paper debt instrument and you’ll see that (excepting the negligible value of the paper, ink and plastic security strip) each such “piece of paper” is intrinsically worthless.
Take a $100 bill in your right hand and a $1 bill in your left. Compare their size and weight. They’re identical. Both have a perceived value and are therefore financial instruments, but which one has more intrinsic value than the other? Which, in fact, has any intrinsic value? Neither. And yet, the piece of paper marked “100” is perceived to have 100 times as much perceived value as the piece of paper marked “1”. (The fact that the two virtually identical pieces of paper have two distinctly different values is evidence that they are “derivatives”.)
Pick up a US Treasury denominated “$100,000”. Pick up another denominated “$500,000”. Which one is bigger or weighs more? Neither. Which has true “intrinsic value”? Neither. Because they’re both financial instruments without intrinsic value, they are derivatives.
Similarly, your paper (and digital) dollars clearly have no intrinsic value. But they do have a perceived value that’s “derived” from something other than the paper and ink. That means your fiat dollars are derivatives.
If your currency is a derivative, it’s intrinsically worthless. If your perceived wealth (stocks, bonds, cash, retirement funds, etc.) is derivative, it is therefore illusory and subject to “magically” vanish at any moment.
You may find that insight scary. If your fear is too great, you might turn away from the truth. You might laugh at the idea that your cash and your retirement funds are derivatives. You might smirk that, of course, your paper wealth has real value. It couldn’t possibly be “intrinsically worthless”.
But defining a paper debt-instrument as an asset is consistent with my definition of derivatives. A debt is an absence of value—a negative value. There is no positive intrinsic value in a paper debt-instrument. And yet, our monetary system treats paper debt-instruments as “assets”. We’ve given our debts a perceived value derived from some other source. But those debt-instruments are clearly without any positive intrinsic value.
Therefore, according to my definition (and Wikipedia’s), all paper debt-instruments are derivatives. They have a perceived value that’s derived from something else, but remain intrinsically worthless.
The perceived value of our debt-instruments is derived from the debtor’s promise to pay the debt. The value of the debtor’s promise is derived from his life’s potential capacity to repay the debt. But no mere promise can be construed as a tangible value. If the debtor dies or goes bankrupt, his promise to repay the debt will be worthless—as will the debt-instrument which has no intrinsic value.
The derivative process is a kind of reverse “magic” act where the magician (banker) stuffs one live rabbit into his hat and then pulls out 100 “paper” (“derived”) rabbits that are accepted by the audience as being as real and valuable as the original rabbit. But if you’re even called on to make a rabbit stew with a paper rabbit, you’ll see that the 100 “derived” (paper) rabbits are not equal to even one real rabbit.
Thus, the process of “derivation” can be described as a kind of financial sorcery.
OK—describing derivatives as “financial sorcery” may be going too far.
But if derivatives aren’t evidence of abracadabra! sorcery, they’re certainly evidence of illusion. If not, how do you explain the presence of up to $1.4 quadrillion worth of “derivatives” in the world when the world’s Gross Domestic Product is only about $70 trillion?
How can we explain that the officially-recognized sum of derivatives is somewhere between 10 and 20 times the world’s total annual production? That ratio can’t be real. It must be illusory.
That illusion is made possible by the fact that the derivatives have no intrinsic value—which would be limited and precise. Without an intrinsic but limited value, a financial instrument can be presumed to have any value we assign to it One intrinsically-worthless piece of paper can be presumed to be worth thousands, millions or even trillions of dollars.
According to the Boston Consulting Group’s 13th annual Global Wealth Report, the world’s total financial wealth (stocks, bonds, cash, etc.) is about $135 trillion. How do we explain that the total sum of derivatives ($700 trillion to $1.4 quadrillion) is somewhere between five and ten times greater than the size of the world’s recognized financial wealth?
Part of the explanation may be that the distinction between “financial wealth” and “derivatives” is arbitrary and meaningless. Most of both classes of wealth are “derivatives”.
Pick up a paper stock certificate. Hold it in your hand. Inspect it for “intrinsic value”. It has none. Yet it does have a perceived value. No intrinsic value + perceived value = derivative.
Same thing is true for commodity certificates, bank accounts, retirement accounts, and virtually all paper financial instruments. They have perceived value, but no intrinsic value. That makes them derivatives.
Therefore, the world’s total wealth is not $135 trillion in “officially-recognized” financial instruments like stocks and bonds. Instead, the total financial wealth consists of that $135 trillion in “officially-recognized” derivatives plus the other $1.4 quadrillion in “unofficially-recognized” derivatives. Thus, the world’s total financial wealth works out to be about $1.54 quadrillion in derivatives—and every bit of that $1.54 quadrillion is intrinsically worthless.
The world’s paper wealth is intrinsically worthless. The whole, damn financial system is only an illusion. More, it’s an illusion that’s become so irrationally large that not even “magicians” like David Copperfield or Barack Obama can’t sell it to the audience. That’s why most of the world has stopped buying US Treasuries (derivatives; irrational illusions) and the only remaining buyer is the Federal Reserve (the magician’s helper).
All of which may explain the derivatives’ seductive appeal. The financial institutions that are empowered to make, sell and profit from derivatives can attach almost any price (perceived value) they please to any intrinsically-worthless piece of paper. That power can generate virtually unlimited (but illusory) perceived value and perceived wealth.
The world’s major financial institutions aren’t spinning “money” out of thin air—they’re spinning derivatives. More, they’re spinning an irrationally large supply of derivatives.
Under the Law of Supply and Demand, whenever the supply of anything becomes excessive, the price of that thing must fall. Sooner or later, the world will realize that the $1.4 quadrillion worth of derivatives is an irrational over-supply and the price (perceived value) of derivatives will fall. Virtually everyone caught holding paper derivatives will lose his assets.
Nothing New Under the Sun
Although the explosion in the supply of derivatives is recent, derivatives aren’t a recent invention. By my and Wikipedia’s definitions, we’ve had derivatives (paper debt-instruments, promises to pay, paper or parchment deeds to land or other properties) for thousands of years.
So, I’m not writing this article to complain that derivatives are necessarily bad.
I’m writing this article to explain that:
1) Virtually every paper financial instrument is a derivative and therefore intrinsically worthless.
2) Derivatives aren’t some exotic variety of financial instruments that most mortals will never see or encounter.
3) Instead, we deal with derivatives every day. Every time you touch a dollar bill, a credit card, a check, a bank loan or a retirement fund, you’re touching a derivative.
4) Thus, derivatives aren’t rare; they’re as common as corn cobs—except that corn cobs have some intrinsic value while derivatives do not.
5) The supply of derivatives has grown so enormous that it’s become irrational.
6) Being irrational, it seems certain that the entire derivative “illusion” will collapse in the foreseeable future.
7) In the event of such collapse, those holding paper financial instruments (that are derivatives and therefore intrinsically worthless) could suddenly see their “illusory” wealth vanish.
Seeking Intrinsic Value
So, how do you protect yourself from a financial system composed of an irrational supply of intrinsically-worthless derivatives?
The answer’s obvious. You convert your derivative wealth (cash and credit) into physical things that are tangible and therefore have intrinsic value.
A bushel of corn has intrinsic value.
An acre of land has intrinsic value.
Tools, cars, firearms, bullets, water all have intrinsic value.
Anything physical has some intrinsic value. Anything that you can own and possess that has physical substance will have an intrinsic value that can’t magically “vanish” if our derivative world collapses.
But, a bushel of corn is not a financial instrument. Neither is an acre of land, a car or a rifle. Yes, they can be traded in a barter system, but none of them can be truly described as “financial instruments”.
If you want a financial instrument that is not intrinsically worthless . . . if you want a financial instrument that is not a derivative . . . If you want a financial instrument that will survive the coming crash in derivatives—I can think of only two possibilities: gold and silver.
Gold and silver are both recognized as “monetary metals”. That makes them “financial instruments”. Both are “liquid” in that they are easily traded. Both are capable of storing your wealth over long periods of time. Both have intrinsic value that’s been universally recognized for several thousand years.
Physical gold and silver that you can hold in your hand can’t be derivatives. They can’t be intrinsically worthless. They are therefore the only financial instruments that will survive if and when our “derivative” monetary system collapses.