The Derivative Market Vigilantes (and why you should care!)

Okay, this is a very interesting story that's unfolding behind the scenes, but before I can really speak to it, I need to describe how financial derivatives work, and why you should care.

A derivative is a contract that guarantees that one party (the buyer) will buy some commodity or asset (called the underlying) at an agreed upon price from the other party (the seller) on some agreed upon future date. This kind of financial instrument was originally designed to protect businesses from volatility. For example, a wheat farmer could sell a wheat derivative that would mature around harvest time, and be guaranteed a satisfactory price for his wheat. This would protect him/her against wheat prices that were too low make a reasonable income from the farm. Southwest Airlines was virtually the only airline that sailed unscathed through the reign of triple-digit oil prices in 2008, because it was a buyer of long-term oil contracts through the derivates market at what ended up being prices that were much lower than maket prices. These kinds of trasactions appear to me at least to be beneficial for both parties because they provide the kind of certainty and advanced planning that allows a business to run smoothly. And this would be fine and dandy if this is what derivatives really were all about.
Instead, there is a little shortcut in this contract called an option. This bit of convenience is actually the central problem...
"A futures contract gives the holder the obligation to make or take delivery under the terms of the contract, whereas an option grants the buyer the right, but not the obligation, to establish a position previously held by the seller of the option. In other words, the owner of an options contract may exercise the contract, but both parties of a "futures contract" must fulfill the contract on the settlement date. The seller delivers the underlying asset to the buyer, or, if it is a cash-settled futures contract, then cash is transferred from the futures trader who sustained a loss to the one who made a profit" (Wikipedia)
So the option allows the buyer and seller to simply settle the monetary difference of the contract, rather than for the seller to actually sell the underlying to the buyer. For the actual farmer, this might allow him to simply sell his grain to his local distributor for $10/bushel and then (let's suppose he entered into a $15/bushel futures contract), he could collect the extra $5 from the buyer of the derivates contract. While this may be more convenient than having to deliver the physical asset to the actual buyer, it changes the real nature of the trade. Suddenly, the seller doesn't have to actually be a maker or seller of the underlying asset. The buyer doesn't have to actually take possession of the underlying asset. In this scerario, the derivative is nothing but a bet between these two parties on what the future price of that good will be. In the event that the buyer wants to take physical delivery, the seller could act as a dealer by then going on the open market, buying the underlying asset in the open market, and then selling it to the buyer at the previously-agreed-upon futures price.
Less than 1 percent of futures contracts traded today are settled through physical delivery. The rest simply cash out between the parties for the difference. Since so few of these contracts actually deal in the exhange of the underlying asset, the trade in futures contracts is not limited to size of the physical market. I've read estimates of the size of the derivatives market that range from $600 trillion to over 1 quadrillion dollars. This is somewhere between 10 and 20 times the size of world GDP. The U.S. debt clock currently pegs it at $632 trillion. So while the supposed utility of the derivative contract is to hedge against volatility and provide certainty, due to the size of the market, derivatives actually act as volatility amplifiers. Small changes in the price of underlying assets lead to huge flows of money and can wreak havoc on institutions that have made poor bets. Through the use of derivatives, things like oil, wheat, cotton, gold, etc have become nail bombs. There are even derivatives contracts on non-tangible assets like currency and interest rates. Similarly to the case of physical goods, small changes in interest rates could cause massive transfers of wealth and cause great destruction just because of all the bets outstanding on them.
Anyone can buy and sell these contracts, and the biggest buyers and sellers are the huge investment banks and hedge funds, essentially gambling in the biggest casino in the world. These entities do not want to be involved in the physical delivery.
"Buyers of commodity futures contracts are obligated to take purchase of the underlying commodity when the contract expires. This could entail paying a large sum of money, since the margin deposit was only about 10 percent of the contract value and the balance would be due when the commodity was delivered. The trader would also have to arrange for the delivery and storage of the gold, corn, orange juice or whatever commodity the contract involved. Futures traders avoid the possibility of delivery by selling an offsetting contract or rolling the contract out to a future delivery month. Futures brokers do not want to go through the delivery process, so will contact traders to make sure they do not receive an unexpected delivery. Do not go on vacation with an open futures contract in your trading account. " (ehow.com)

So essentially, Goldman Sachs does not want to be responsible for actually conducting physical trade. That involves transaction, delivery, and storage costs, and such mundane real world transactions are no where near as lucrative as the pure bets!
There is a deeper problem, however. As should be obvious from the size of the derivatives market relative to the real economy, only a small fraction of the total outstanding derivates could be settled in physical delivery given that the trade in futures contracts are typically 10 to 100 times the size of trade in the underlying asset.
Enter J.P. Morgan. According to Max Keiser, J.P. Morgan has recently been involved in naked shorting the silver market through silver futures contracts. Naked shorting is borrowing money to take a short position (or a bet that the underlying asset will drop in price). In the futures markets, taking a short position is as simple as being the seller of the contract - because if the commodity drops in price relative to the agreed-upon futures price, you make money selling it at that higher price (or cashing out, as the case may be). According to Max, the J.P. Morgan short position contracts are covering $1.5 trillion in silver - much more silver than actually exists. Max has started a campaign that has gone viral on the internet called 'Crash J.P. Morgan, Buy Silver'. The idea is that by taking physcial silver off the market (and I'm not sure if he means buy derivitives contracts and demand delivery or if taking it off the market in other ways would obtain the same result) the price will be bid up and J.P. Morgan will not be able to cover its short position. If enough silver is taken off the market, it would expose the over-leveraged nature of the derivitives market and destroy the value of all 'paper silver'.
Here's Max:



Max also interviewed Jim Willie about an attempt by so-called 'gold vigilantes' to force the hand of these big banks that were trading all-of this mega-leveraged gold that essentially only existed on the margins:



This is the same exact principle as a run on the bank, but in this case, it is an attempt by wealthy foreigners to prevent Western banks from manipulating these assets. I think this is a battle that will remain behind the scenes because of the stakes involved, unless enough people become aware of things like this viral Crash J.P. Morgan campaign. But be aware - the crisis is coming. It is a crisis of confidence that has its roots in the ridiculously over-leveraged nature of the derivatives market -a market that dwarfs all other financial and real markets. Unless this leverage can all be unwound safely - and I'm not sure it can - this derivatives market is going to throw the world into financial turmoil. And keep in mind, it already has to some extent. Mortgage backed securities, and collateralized debt obligations (the so-called toxic assets that are the reason for all of the bailouts) exploded in nail-bomb fashion in 2008 and continue to spray their shrapnel through foreclosuregate and through the backdoor purchase of this garbage by the U.S. government. The reason the world fell to its knees due to falling home prices was due to the massively leveraged bets on those home prices.
Be forewarned. The finanical crisis is far from over and the world governments are running out of tricks to convince people that everything is stable.