This youtube clip from the Money Project came out earlier today:
Basically, it’s a tidy (and updated) version of this infographic:
It’s the kind of thing that I find very one-sided. Although obviously, if you’re going to call yourselves “The Money Project”, then you’re going to be very focused on money as a ‘thing’ rather than a measure of transactions between people. To say nothing of the fact that there is some confusion here between ‘physical money’, debt, the stock market, and derivatives. Those are very different things!
But perhaps one of the biggest misconceptions here is the derivatives market. Let me give you an example:
- An insurance contract is a derivative, because the value of the insurance policy is derived from the value of the asset being insured.
- So if I insure my new car for replacement cost at $20,000 – then that ‘$20,000’ notional value gets added to the total value of the derivatives market up top.
- Would we really call that $20,000 ‘money’?
I mean, in an extreme setting, you might say “What if all the cars and all the houses and all the other insured stuff combusts at the same time – what then?” But if that happened, it would be the Apocalypse, and I’m pretty sure that nothing would survive – least of all the financial system.
It almost wouldn’t be worth pointing out that my insurance contract excludes Acts of God (and wars, rioting, and extreme weather, for that matter).
The derivative situation gets even worse when you consider things like interest-rate swaps (fancier derivatives):
- Let’s say that I have a $1 million loan that pays interest at LIBOR (a floating rate).
- But now let’s say that I’m now worried about Janet Yellen raising interest rates – so I go to the bank and ask them for an interest rate swap.
- The bank says “Fine, you pay us 2% interest at a fixed rate on the $1 million, and we’ll pay you the LIBOR interest amount, and you can pay that to your lender”.
- Ta dah! A derivative contract based on a notional amount of $1 million. So we add an extra $1 million to the derivatives market.
- A few weeks later, I realise that I want to change my mind and go back to a floating rate, because Janet Yellen seems to have changed her mind about increasing interest rates.
- So I go back to the bank and ask them to cancel the interest rate swap.
- And they say to me “Look, we can’t cancel the contract.”
- So I go to a second bank, and take out a second interest rate swap, where the second bank says “Fine, you pay us LIBOR+1% on the $1 million, and we’ll pay you 2% interest at a fixed rate on the $1 million.”
- Ta dah! A SECOND derivative contract based on a notional amount of $1 million. So we add another $1 million to the derivatives market.
- How this works: I’d pay the second bank my actual interest, and they’d give me the interest to pay the first bank, who’d in turn give me the interest to pay my lender.
- That is: I’m engaging in new derivative contracts to offset older derivative contracts.
- And all that we’re really talking about is interest. I went from paying LIBOR, to paying a 2% fixed rate, and then back to paying LIBOR+1%.
- In practice, I’m just playing around with minor savings on about $20,000 worth of interest.
- But in the diagram up top, I created an extra $2 million of notional exposure to be added to the ‘value of the derivatives market’.
It’s a bit nonsensical.
But still fun to talk about.
Rolling Alpha posts opinions on finance, economics, and the corporate life in general. Follow me on Twitter @RollingAlpha, and on Facebook at www.facebook.com/rollingalpha.