A bank makes an investment in item A. It then
considers the possibility that item A may fail and
it will lose its investment. Not wanting to lose the
investment, the bank hedges its bets and insures itself
by investing money in item B. Item B is a promise
that if item A fails, item B will pay out – item B
derives from item A – hence, it is a derivative, a
Credit Default Swap - item B is swapped for item A,
should item A default on its credit.
Item A is usually something that exists in the real
economy – a loan to a factory, a business or a
mortgage. The problem arises with item B – the
derivative. It is fictitious. It does not exist in the real
economy. It is a bet to cover the bank just in case
item A goes wrong.
The biggest problem facing the global financial
system today is that these CDSs are not treated as
fictitious. They are treated as real commodities and
traded for real money. It is estimated that there is
$25.5 trillion worth of derivatives in the financial
system today being traded between banks, pension
funds and hedge funds. To put that into perspective,
the GDP of the United States in 2011 was $15
trillion.There is a major danger of these unraveling
and precipitating a secondary financial crisis in the
near future.
16
What is presented here is a bird’s eye view. For
what it is worth, I would make the following
recommendations:
1) The Treasury should reclaim the right to create
money from the Federal Reserve, eliminating the
initial interest owed,
2) The Glass-Steagall Act should be reenacted,
preventing investment banks from leveraging the
deposits of retail banks,
3) Credit Default Swaps should be phased out,
encouraging more prudent custodianship of the real
economy,
4) Transactions between financial institutions should
be taxed by 1% (currently banks and financial services
companies pay no tax whatsoever on transactions),
discouraging high-frequency trading conducted
by computer algorithims, thus requiring banks to
consider the necessity of each transaction more
carefully, with the result that they will operate more
in the real economy, investing in things that create
actual value on the ground,
5) Governments should put out tenders for
considerable programmes of public works
infrastructure,
6) The real economy could be kick-started
by