Policy #11 - Derivatives: Why does Warren Buffet call them the "financial Weapons of Mass Destruction"?

Policy:

Derivative contracts are not allowed. For someone to sell something they must have ownership and possession of it at the time of sale. It is allowed, however, for manufacturers and farmers to sell the goods that they will produce in advance subject to certain conditions.

Proofs:

Derivatives are not actual assets in themselves. Rather they derive their value from other assets. The Office of the Comptroller of the Currency defines derivatives as follows:

“A derivative is a financial contract whose value is derived from the performance of underlying market factors, such as interest rates, currency exchange rates, and commodity, credit, and equity prices. Derivative transactions include an assortment of financial contracts, including structured debt obligations and deposits, swaps, futures, options, caps, floors, collars, forwards, and various combinations thereof.”

A good example of a derivative contract is a call or put option. The following Khan Academy video walks through how the call option works:

The summary is that the actual derivative contract has no value in and of itself. Instead, it derives its value from some other agreement. For example, the call option gave the right to buy the stock at a certain price from a certain party. A put option, on the other hand, gives the right to sell a stock at a certain price. In general, stock traders buy call options because they think that the stock is going to go up and put options because they think the stock is going to go down.

 From an Islamic perspective, call and put options are illegal because stocks are illegal as previously discussed. Similarly, any derivatives that derive their value from debt (e.g. mortgage-backed securities, collateralized debt obligations, etc.) credit default swaps, and the like are also forbidden because interest is prohibited. 

 So what about foodstuffs and other real products?

 Selling that which one does not own and that whose ownership has not been accomplished is forbidden due to the ahadith concerning this matter. These ahadith are general and apply to all sales where the seller either does not own the goods or has not taken full ownership of the goods. He (saw) said:

“I said: O Messenger of Allah, there comes to me a man asking me to sell what I do not have to sell then I buy if from the market. He said: Do not sell what you do not have” [Ahmad].

And

“It is not allowed to borrow and sell, nor two conditions in one sale, nor a profit that is not included nor the sale of what you do not have” [Abu Dawud].

The expression of the Messenger (saw) of “what you do not have” is a general statement which includes one’s ability to deliver what you don’t completely own. This is strengthened by the ahadith which came with a prohibition of selling that which is not possessed in that whose completion of ownership is conditioned upon taking possession. This indicates that whoever buys that which requires taking possession until his purchase is completed is not permitted to sell until he takes its possession. So its rule became the rule of selling that which he does not own due to the Prophet (saw)’s statement:

“Whoever sells foodstuff, he should not sell it until he pays its due” [Al-Bukhari]

However, these general evidences have been specified in other than the sale of advance credit. As for advance credit sale, the Shar'a has excluded it from the prohibition and permitted it. He (saw) said:

“Whoever pays in advance for something, then he should for a specific measure and a specific weight and for a specific period” [Al-Bukhari].

The "salam" is the "salaf" with two "fatha" in weight and meaning. It is the one who delivers present compensation for a described compensation as surety for a period i.e. advance money as the price for a good he will possess after a time for a specific period. The advance credit sale is a category of sale which is contracted according to what a sale is contracted and by the word "salam" and "salaf". And it is (also) referred to as "aslam" and "aslaf". As a result, the same conditions are applied as in a sale.

The transaction between people in salam and tasleef takes place because they are in need of it particularly the farmers and traders. The owners of crops and fruits need expenditure for themselves and upon it to complete what these crops and fruits require of work. Money could become scarce such that they do not have it, so they sell their produce before it emerges for an advance price which is taken possession of immediately in the contract session (majlis al-‘aqd) upon the condition of delivering the good to the buyer when the imposed period falls due. The trader would sell the goods (not in his possession) for a specific period which they would determine, while taking possession of the price immediately in the contract session upon condition of delivering the goods when the agreed upon period becomes due.

The Sunnah clearly establishes the permissibility of advance credit sales,. as narrated from ibn Abbas (ra) who said:

“The Prophet (saw) came to Madinah and they would pay in advance for fruits for one or two years so he said: Whoever pays in advance, let him pay in advance for a specific measure and specific weight for a specific period” [Muslim]

 And in a narration:

“We would pay in advance at the time of the Messenger of Allah (saw), Abu Bakr (ra) and Umar (ra) in wheat, barley, dates and raisins to a people who did not have it with them” [Abu Dawud].

With that in mind, the ability to deliver on such an advance sale requires that the seller can manufacture the goods or agriculturally cultivate them. Otherwise, it falls into the original prohibition. For example, if Jim, a retailer, wants to sell bananas that he will get from Jack next year, he must take possession of the bananas before selling them (or he would be breaking the rule of selling that which he doesn’t own).

Propaganda:

Derivatives are seen to be mainly beneficial from a risk management perspective. Investopedia also argues that derivatives assist with “price discovery”. That is, the price outlined in the derivatives contract will be the de facto price as that is what the market players are willing to agree on this price. The article also argues that derivatives help reduce transaction costs and improve market efficiency.

Counter-Propaganda:

Do they reduce costs and improve market efficiency? As for the ability to cut costs, we can see the debacle by way of the AIG bailout as proof that this is not true. AIG needed $85 billion to be bailed out because they couldn't cover the bets they made on the subprime mortgage-backed securities. I made a similar argument on the post on insurance. When the insurance companies really need to be there, they can't because they can't predict the future and so they are in a sense useless. On making the market efficient, the reality of derivatives is that they are so complex. Consequently, it's hard to understand what the actual exposures are – as evidenced by the AIG bailout.

Price discovery: As noted in the proofs section, there is an ability to sell agricultural products and manufactured goods in advance. However, will the contracted price influence the market price? It will influence the price – but like any deal that is being made between a buyer and a seller. That being said, the world has been setting prices between buyers and sellers for thousands of years without the use of derivates. Although it could be argued that futures contracts are helpful in determining prices, the reality is that this alone is not a compelling reason to keep such things around.

Risk management is societal in nature: Although the underlying risk associated with many derivatives is illegal in nature (e.g. stocks, bonds, mortgages, etc.), the point is that the risk needs to be managed by society and not the individual. As noted in the post on insurance, when a disaster strikes, the State can use the taxes its collected to help those devastated by the wildfire, tornado, etc. If the State doesn’t have any money, it can ask for voluntary donations to help those in need. If that is insufficient, then it must tax the wealthy. The irony is that the 2007 Financial Crisis – which was precipitated by derivatives (mortgage-backed securities) – proved this point. Because AIG couldn't cover this catastrophe on their own, they went to the coffers of society.

Points to consider:

Derivatives are a disaster of epic proportions:

Sometimes it can be hard to see when something so dangerous is lurking around, like mad-cow disease or other pandemics. However, when it comes to derivatives, there is no mistaking how dangerous these things are. Billionaire Warren Buffet "has made his disdain for derivatives—a class that includes the credit default swaps that helped exacerbate the 2008 financial crisis—well known. He called these things “financial weapons of mass destruction” in 2003. He again reiterated his concerns about the contracts during Berkshire Hathaway’s annual meeting this year, calling the group of complex derivatives a “potential time bomb” on the balance sheets of banks that is vulnerable to economic shocks”.

Why are they such a disaster?

 Firstly, they are not real. We will discuss this issue in the FIRE section, but the point is that they are paper constructs that are not based on reality. As economist Michael Hudson noted, “A derivative is a bet on whether a stock, or a bond or a real estate asset, is going to go up or down. There’s a winner and a loser. It’s like betting on a horserace. So the biggest bank lending for gambles – not for real production, not for investment, but just for gambles”. In contrast to buying a tangible asset or service, you can assess what you are buying and understand whether it is going to meet your needs.

 The second problem is related to the first. It is not clear how such contracts behave as a collective mass. As was seen with the Credit Default Swap of the financial crisis, the companies buying the mortgage-backed bonds thought they were getting AAA-rated bonds; meaning that they have a lower rate of failure. However, instead, they were buying "toxic assets." There was plenty of blame to go around from Alan Greenspan’s hesitance to regulate derivatives to the failure of the credit rating agencies.

The underlying complexity, however, is a significant issue. As Jamal Harwood, an Islamic Economist with Hizb ut Tahrir, points out in a white paper published after the Financial Crisis, “the complexity of some of the financial products being traded has grown exponentially. Regulators at the best of times are hardly the most agile of entities, in a world where product innovation is rapid and fast changing, regulators struggle to keep up.” He also notes that the regulators are kept in check by the political system that allows politicians to get legally paid off through campaign contributions. For example, US senators can spend two-thirds of their time fundraising. Therefore, the combination of a weak regulatory regime and a complicated matter results in a system that is prone to vulnerabilities that are difficult to monitor.

To understand the level of complexity associated with such financial instruments, let's look at captions and credit ‘swaptions’. A caption is an “option on a cap. In other words, a caption is an option to buy or sell an interest rate cap whereby the holder has the right, without the obligation, to purchase or sell a cap with an agreed-upon strike rate on (if the caption is European-style) or before and up to (if the caption is American-style) a given date against a specified premium”. While a credit swaption is an “option on a credit default swap, it provides the holder with the right, without the obligation, to enter into a credit default swap at a future date. More specifically, the holder is enabled to buy (call) or sell (put) protection on a specified reference entity for a predetermined future time period for a preset spread. The option is embedded with a knock-out feature, allowing it to knock out if the reference entity defaults during the life of the option.”

Consequently, a caption depends on another derivative, an interest rate cap, which then is likely tied to a  debt obligation held by some party. There is also a “credit swaption," which is a bet on credit default swap (the same instruments that nearly destroyed AIG), which is a bet on whether someone is going to default on his or her loan. This means underlying derivatives is a complex web of transactions that can expose the economy to sudden shocks and crisis.

And it is not just what occurred in 2008.

We only need to look to the Long-Term Capital Management (LTCM) crisis to see how this web of transactions break apart when something goes “awry” in the real world. (I put awry in quotes because it’s not fair to describe a natural occurrence of things as a “problem”: life happens. The actual issue is the system itself. It should be capable of handling such events.)

Long-Term Capital Management (LTCM) was set-up by several geniuses who won Noble prizes for setting up the infamous Black-Scholes options pricing formula. In summary, LTCM use derivative contracts to take the $120 billion (based on $4 billion worth of equity) to purchase derivative contract that had a notional value of $1 trillion. They had bet that the short-term interest rates were going up and long-term interest rates were going to go down. And because LTCM had some geniuses on-board, the other large players on Wall Street mimicked their trades. However, the Russians defaulted on their debt in August 1998 causing the spread to go the other way. The market panic was calmed down by the intervention of the Federal Reserve Bank of New York (along with other banks) who lent LTCM the necessary funds to sell their assets without causing a major meltdown. (For more details on this, check out this excerpt from the “Wizards of Money” podcast.)

The central point to this example is the fragile nature of these derivatives. The Russian default on their debt caused a chain reaction that almost caused a major financial crisis. As noted in previous posts, the Capitalists can paper over these types of things. However, they are just giving themselves more rope to hang themselves with – as evidenced by the actual financial crisis that did occur 10 years later). 

Derivatives emanate from freedom

When looking at derivatives, it is important to remember that they are a creature of the enlightenment. The essence of derivatives is the “freedom of ownership”: when it comes to the economic sphere anything goes – as long as the two parties agree to the contract. In Islam, all contracts and their clauses must emanate from the Quran and Sunnah.

The FIRE Rages On

Derivatives are the quintessential example of the Finance, Insurance, and Real Estate economy that we discussed in the post on insurance.

According to the Bank of International Settlements, at the end of June 2018:

  • “The notional value of outstanding OTC [over-the-counter] derivatives increased from $532 trillion at end-2017 to $595 trillion at end-June 2018. This increase in activity was driven largely by US dollar interest rate contracts, especially short-term contracts”

And:

  • “The gross market value of OTC derivatives continued to decline, nearing $10 trillion at end-June 2018 from $11 trillion at end-2017 - compared with the peak of $35 trillion observed in 2008. This decline reflected in part ongoing structural changes in OTC derivatives markets.”

(Note: Over The Counter (OTC) derivatives means that they are transacted by two parties directly, i.e. without the supervision of an exchange; see here. For example, stock trading occur on exchanges and are highly regulated.)

They mainly about taking positions on currencies, stocks, bonds, mortgages, etc. without investing in the actual productive economy of goods and services. As noted in the propaganda section, there is an argument about how these things manage risk. However, the profits made from this type of risk management are a drain on the real economy because that money is not going to the actual generation of goods and services. 

Wall Street’s gambles flatten Main Street

In 2012, oil prices broke records with the cost of Brent crude costing almost $112 US per barrel. In contrast, a barrel today costs about $54 per barrel. What was to blame? Speculation. According to CNN, “investors in oil contracts like big banks, hedge funds and others that don't actually use crude oil or gasoline…In the past two months the amount of contracts held by investors that bet the price of oil will rise jumped 45%.” NY Times went further and noted:

“Today, speculators dominate the trading of oil futures. According to Congressional testimony by the commodities specialist Michael W. Masters in 2009, the oil futures markets routinely trade more than one billion barrels of oil per day. Given that the entire world produces only around 85 million actual “wet” barrels a day, this means that more than 90 percent of trading involves speculators’ exchanging “paper” barrels with one another…Because of speculation, today’s oil prices of about $100 a barrel have become disconnected from the costs of extraction, which average $11 a barrel worldwide. Pure speculators account for as much as 40 percent of that high price, according to testimony that Rex Tillerson, the chief executive of ExxonMobil, gave to Congress last year.” [Emphasis Added]