Bitcoin has caused the entire human race to wrestle with many of the contrived financial instruments of the last century and it’s about to do the same of what is perhaps the biggest albatross around the neck of the current economic system.
A derivative is a financial contract which derives its value from the performance of another entity such as an asset, index, or interest rate, called the “underlying”. Derivatives are one of the three main categories of financial instruments, the other two being equities (i.e. stocks) and debt (i.e. bonds and mortgages). Derivatives include a variety of financial contracts, including futures, forwards, swaps, options, and variations of these such as caps, floors, collars, and credit default swaps. Most derivatives are traded over-the-counter (off-exchange) or on an exchange such as the Chicago Mercantile Exchange, while most insurance contracts have developed into a separate industry.
There are a number of fallacies associated with the benefits of them. “A derivative is a financial contract which derives its value from the performance of another entity such as an asset, index, or interest rate” meaning it is a wager or a bet. People bet on a lot of things such as lotteries, dog and horse races, sports games, games of chance etc. but are the bets considered an asset class? Could a ticket in a lottery that hasn’t been drawn be used for collateral for a loan for example?
“Derivatives are one of the three main categories of financial instruments, the other two being equities (i.e. stocks) and debt (i.e. bonds and mortgages).” And of the three, mortgages have already collapsed (but not totally because of being propped up by global bail outs). Many believe a second (bonds) are a bubble ready to burst at any time.
But the third (derivatives) are unregulated and go largely unreported. The size of the market is staggering – “The Economist magazine has reported that as of June 2011, the over-the-counter (OTC) derivatives market amounted to approximately $700 trillion, and the size of the market traded on exchanges totalled an additional $83 trillion … For perspective, the budget for total expenditure of the United States Government during 2012 was $3.5 trillion, and the total current value of the US stock market is an estimated $23 trillion. The world annual Gross Domestic Product is about $65 trillion.”
With Tera’s announcement of offering derivatives on Bitcoin the claims that derivatives will smooth out the Bitcoin price (and not just Bitcoin but all financial markets) will be put to the test.
While I’m not a financial expert I fail to see derivatives in Bitcoin doing anything. I fail to see how someone buying $100,000 of Bitcoin “in the future” will affect the market any differently than if they were to purchase $100,000 worth of Bitcoin in the market. But when they purchase Bitcoin at least they own something.