1. Explain the concept of derivatives and their growth in the global marketplace
2. Describe the conditions leading to market de-regulation and then increased regulation

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DERIVATIVES

A more complicated category of instrument is the derivative. A derivative's value comes from the underlying asset it is representing. Earlier we spoke of mortgage backed securities - these are derivatives based on the value of the underlying asset - the house and the mortgage that is paid on it. The value of the derivative is tied to what happens in some external financial situation. Futures and options are the two key examples.

In the case of an option-based derivative, a premium is paid for the option (but the not the obligation) of making a certain transaction for a certain period of time. For instance, you could pay a premium to someone in exchange for the option of buying a certain stock at a certain share price at any time in the next six months. If you decide to buy the stock in that period you can pay the pre-determined price, whatever the market price currently is. The person who sold you the option is hoping that he will not lose money when the time comes; in the mean time he has collected your premium payment.

A forward-based derivative (these are often referred to as futures) is a commitment to buy something at a fixed price at a later date. For instance, you could enter into a forward contract to buy 100 tonnes of pork bellies at $250/tonne six months from now. If pork bellies are selling at a market price of $350/tonne when the time arrives, the buyer will most likely end up making a profit on the deal; if they are now selling at a market price of $150/tonne, the buyer is forced to pay $100 more than the market price and the seller profits.

THE LOGIC OF MODERN MARKETS AND THE CRISIS OF 2008

While we did see some very primitive "financial trading" in the markets of Uruk as far back as 2500 BCE, the first modern financial market was the Amsterdam stock exchange established in the early 17th century. The Dutch were pioneers in many of the modern day stock activities we see. They invented concepts such as short-selling, option trading, debt equity swaps, and other speculative instruments that we still use today.

Stock, bond and currency markets now exist in every major city in the developed world. The biggest markets are in the United States, Canada, China, Hong Kong, India, Great Britain, Germany, France, and Japan.

The essential functions of these markets are to facilitate a number of activities:

• The raising of capital (in the stock markets)
• The transfer of risk (in the derivative markets)
• International trade (in the currency markets)

Overall, these markets work well and most of the people involved in them are basically honest. However the markets are tools, and like all tools they can be used both for good and bad. There have been plenty of occurrences of fraud initiated by people driven by excessive greed. Some well-known examples include the leaders of Enron, Tyco, WorldCom, Hollinger (our own Conrad Black), and the infamous Bernie Madoff, the mastermind behind one of the world's largest Ponzi schemes.

Modern developments in financial markets have been driven largely by Britain and the United States, who have generally been seen as the bastions of free enterprise and privatization. Former UK Prime Minister Margaret Thatcher and US President Ronald Reagan championed free and open markets with little regulation and control throughout the 1980s, and have left us with a world of markets that many people think are precarious and full of risks both to individuals and to larger organizations and whole countries.

The 2008 financial crisis shook many people's faith in freely operating financial markets. Governments around the world today are moving in on many of these markets, intending to keep a closer watch on them and introduce tighter regulations. Public opinion has swayed since the 80s and many people feel strongly that government does need to become involved to help protect the average investor from failures in the marketplace. Apart from the practical failures that occurred in the 2008 crisis, many feel there was also a serious moral and ethical failure at the heart of it. Unbridled greed does not necessarily serve the good of the majority.

Financial markets are now truly global. Risky and sometimes dubious new products like derivatives move freely across borders. The impact of these schemes can go far beyond the individual or even a company. You may recall the mortgage-backed security discussed earlier in the course. An investment company buys up a pool of residential mortgages from a number of banks and puts them together into a single security (kind of like a mutual fund). The security can then be resold on the global financial markets as a supposedly safe investment, since it is based on the underlying assets of individuals' houses. Homeowners making their mortgage payments provide the financial return for the investors who hold these securities.

This all works well as long as homes are increasing in value and homeowners continue to make their mortgage payments. But it can blow up when housing prices fall and mortgage holders default on their payments, which is what happened in 2008 and nearly triggered a global financial collapse. The fact that these products were sold on the global markets turned the US financial crisis into a global financial crisis and came close to driving the world into a great depression.

While too little government regulation and policy was partially to blame for the situation in 2008 and after, problems with the regulation and policy that did exist also played a part. Some government decisions that may have caused more problems than they solved include

• Legislation in the US forcing banks to lend to underprivileged groups
• Taxation benefits allowing people to write off mortgage payments
• Artificially low interest rates set by the US Federal reserve
• Bank deposit insurance, protecting depositors' investments, but allowing banks to worry less about prudent management
• Government bailouts for major financial institutions, including banks, investment companies, and insurance companies

Deregulation was not all bad. It did make it easier for deserving and responsible businesses and consumers to get credit, and this credit did lead to both economic growth and improved lifestyles. But after 2008, people are less convinced about the virtues of deregulation than they were during the heyday of the 1980s.