About the Author
Stewart Cowley has been working in the financial markets since 1987. He is one of a handful of people ever to have held a triple-A rating by Standard & Poorâs and was awarded the prestigious Gold Medal for long-term investment performance by FE Trustnet. He has also been one of the UKâs most visible fund managers, having written for the New Statesman, the Sunday Telegraph and Citywire. He has made frequent appearances on the BBC and Sky News. His previous books Man Vs Money and Man Vs Big Data have both been bestsellers.
1. Introduction
In his 2003 annual letter to Berkshire Hathaway shareholders, the money-managing goliath Warren Buffett called derivatives âfinancial weapons of mass destructionâ. Many people, even those who didnât know what derivatives were, nodded in agreement â and those who nodded most vigorously knew the least about derivatives. Thatâs because derivatives â financial instruments deriving their value, not from owning something, but from the price movements of something they are related to (like stocks, bonds, currencies and commodities) â are both fiendishly simple and fiendishly difficult to understand.
Or so a lot of people would like you to think.
These prejudices have some basis in truth: derivatives nearly single-handedly brought about the near-collapse of the entire Western financial system in 2008. But, besides this trifling incident, it is arguable derivatives have been given something of a bad rap. This is understandable if you perceive them to be complex and anarchic, but also if the sheer size of derivatives markets turns your knees into quivering jellies.
To give you a sense of perspective, if you were to project all the money and financial assets in the world onto the side of the 102-floor Empire State Building, the first 81 floors would be the derivatives markets. The next 13 floors would be occupied by global debt markets; five floors would be reserved for global stock markets; the remaining floors by actual cash in circulation, gold and real estate. The small blinking red light on the top of the communications tower would be Bitcoin.
As of December 2016, the Bank of International Settlements â the financial organisation owned by 60 member states which act as the central banksâ central bank â calculated that there were derivatives with a notional value of $500 trillion swilling around the world, with profits of $15trn sitting inside the instruments falling under its governance. Fifteen trillion dollars is close to the value of the total annual national income of the United States, a truly staggering number. From the late 1990s, until its near-term peak in 2013, the derivatives market achieved an astonishing 15% compound annual growth rate, making it one of the t...