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A MANIFESTO IN THE MAKING

 

Manifesto Introduction
 
The party defines itself by the five core policies. So that members and non-members clearly understand what the party stands for, these cannot be changed. At present they are principles the details of which will be decided according to the party constitution
 
All other policies will be decided according to the constitution
 
Below is a provisional list of headings for the Mani-festo each with a link to a page
That page contains provisional ideas for discussion.

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4 Banning of exotic financial instruments

 

C. SYNTHETICS

Peter Kellow Simon4 months ago

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To avoid too much reader fatigue I looked at synthetics from a rather greater altitude than bog standard derivatives, but, as you asked, here is some more detail.
To illustrate how synthetics work let's return to placing bets on horses, but look at it in a different way. Imagine a situation without bookmakers as might have existed say in seventeenth century. Nevertheless, there is still horse racing going on. The owners of the horses invest money and time in their horses and hope for a payback if their horse comes in and gets the prize. This is a simple case of speculative investment hoping for a profit.
But what if there are other non-horse owners would like a bit of the action and so would like to put down some money with a view to seeing a return. There are no bookmakers but what the 'investor' can do is to invest their money directly with the horse owner and breeder. The horse owner is happy with this as the increased money at their disposal means they can expand their business, breed more horses and enter more races and stand a chance of winning more prizes. So far, this is exactly like a modern company where investors buy shares, enable the business to be expanded, and hopefully recoup some of the profits.
Now it is easy to see how the scope for investing in horse racing in this way is rather limited and cumbersome. The investor has to deal directly with the horse owner and they have other things to think about and there is clear limit to how far they can expand their business and absorb all the investment money on offer
But then someone has a bright idea for taking up the investment money available. They are completely unconnected with the racing world and really do not give a hoot about it, but they see a financial opportunity to profit from it without going to the trouble of negotiating or buying a share of the business of the race horse owner. Let's call this business Ladbook. Their plan is this. Create a business where 'investors' can place bets (investments, speculations) on a particular horse when neither they nor Ladbook have any financial connection with the horse owners or any aspect of the racing industry.
This means that a whole new form of contract can grow up without any connection with racing except in one respect. The outcome of the investments (bets) is determined by what happens in a race. In the jargon of the financial world, the result of the horse race is called the 'underlier'. It is what gives the Ladbook deal some kind of grip on reality outside and independent of their control.
It is very analogous to a synthetic trade. It can take place without the say-so or the involvement, financial or otherwise, with the industry that provides the underlier. Of course, here the analogy is not quite watertight because a regulated company like Ladbook in the real world does have to contribute some of its profits to the racing industry, but it is easy to see that this is not intrinsic to the set up. Let's assume, for the sake of argument, there is no such benefit to racing.
Now, the introduction of Ladbook has one enormous consequence for the practice of investing/betting on horse. The sky is the limit. When investment meant involving the horse race owner and his company the limit was on the nature of that business and the decisions the owner made. With the separation off of 'investing' in the horses it bred there is no longer any limit to the size of the investments. I don't have the figures to hand but I think it is fair to assume that the size of the bookmaking industry dwarfs the size of the horse racing industry that furnishes its "underliers"
This is exactly the situation with the creation of synthetic deals in high finance. Because there is no longer any need to go to all the trouble of placing your money with some real, functioning part of the economy, the business can be expanded ad infinitum. In my article it was a bit rhetorical to imply there are now no counterparties to the parties, although there is a partial truth there.
To clarify this, return to the Ladbook business, there are two sides to the betting contract, Ladbook and the punter. Ladbook, although a big corporation, is still a relatively small element of the whole economy and so the separation between it and the punters is maintained. Now in the world of mega global finance, the number of players starts to become rather limited and so this separation between accepter of the bet and placer of the bet breaks down. And so the same MegaCorp A can be both accepting from and placing investments/bets with MegaCorp B.
Does this matter? Not at all. That is, until investments start to be called in. This sets off a massive chain reaction leading to the bankrupting of the MegaCorps and the tax payer being brought in to bail it all out, but let's not go over all that familiar scenario again
There is a question in all this that we need to address. Why do the MegaCorps engage in these activities when the risks are there? The first less significant part of the answer runs: they make commissions on the trades (don't forget these are often worth billions, making the commissions enormous). But it the second part of the answer that we need to pay special attention is this: a synthetic contract like most financial contracts can be traded - bought and sold.
To go back to the Ladbook example, once you have placed a bet, you have a contract and one that can be sold (perhaps not officially). Suppose the form of horse you have backed improves. Your contract is for say 12 to 1 but bookies now quote 7 to 1. The horse now has more than a 12 to 1 chance of coming in but your payout will remain at 12 to 1. If you then think about selling your bet it will command a premium. What this illustrates is as follows: we started off with a simple horse racing investment industry, then created from nothing a whole new bookmaking industry and now we have gone further. We have trading in the bets and this is a whole new industry again.
To return to synthetics, when the original contract was made between MegaCorp's A and B the money exchanged was relatively small for the deal was above all about promises to pay in the future. Now once the deal is sold/exchanged the sums are a different matter. We are talking here often large fractions of trillions. So where does it come from? Who on earth has that kind of money? Well, no one actually. But we know someone who can create it out of thin air - our old friends, the banks. This is typically how it works.
A hedge fund has some sizeable amounts of clients' money to place. But this is still nothing like the say 100 billion they need to purchase the synthetic contracts. This is where leverage comes in. What happens is that the bank creates the money and lends it to the hedge fund which is then in a position to buy. Is not there a risk to the bank? None at all, the bank loan is collateralised by the value of the synthetic contract giving it 'security'.
Well, we can joke about that for of course the bank is really insured by the tax payer should it all go belly up.
The point is a whole new financial industry of creating and trading synthetics is created - and megasums are involved. To cope with this the banks create money and so the money supply is ballooned astronomically to enable this new 'industry' to function. Although this industry contributes zero to the real economy it forms a massive, even dominant part, of the money economy and so the money economy enters the stratosphere where only a very limited number of entrants gain access. These are the already superrich that can then further multiply their fortunes
But although existing on a different level to the real economy, it is ultimately dependent on the real economy, and more importantly, the real economy becomes dependent on it. The expansion of the synthetics magnifies again the portion of the money economy that the global superrich control and, as ultimately we need money to run the real economy, governments do not ignore what is happening there. The financial crises of today are caused by the creation of the super financial economy that is parasitic on the real economy of production and trading of real goods and services. The overwhelming power of the members of the superclass buy the legal and political classes leaving the vast majority unrepresented and powerless

 

 


 

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© COPYRIGHT. All content of this website unless otherwise indicated is the copyright of Peter Kellow. You may freely quote and republish content on condition that you acknowledge the author the source and give the link to the website www.democraticrepublicanparty.co.uk

 

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