influence the price and availability of the energy used to heat homes and run factories. They also help set the interest rates borrowers pay on home mortgages and the returns workers earn on their retirement savings. Airlines use derivatives, too. The reason carriers are willing to quote us a fare for a ticket on a flight six months from now is that they are hedging their future fuel costs. The same is true for oil producers and refiners.
Agriculture Futures
Say I am a farmer and I own 444 productive acres—the national average for a family farm. Assume further that I rotate between soybeans and corn, which is common. To keep my farm in business and my bills paid, I need to know a lot. I know my soil and the effects of various weather patterns on my crops. I know what my farmhands cost and what my gasoline costs. I know what my seed costs. I know what my fertilizer costs. What I don't know, though, is what the price is going to be for soybeans come November. So, I add up all the costs for the year—the farmhands, the tractor, the gasoline—and that comes to $6.75 a bushel. But when I go to market, I know from experience that soybean prices could range anywhere from $6.00 to $9.50 per bushel. Those varying prices could spell the difference between windfall profits and bankruptcy.
So how do I transfer that risk to somebody who is willing to bear it? Well, what I can do is enter into a contract on the futures market. I lock in $7.75 a bushel for at least half my production. That way I know that if there is too much supply and bushels are selling at less than my $6.75 cost, I'm going to make at least a dollar more and keep my farm solvent. Of course, I'm giving away some of my upside if the price goes up to $9.50 a bushel. But at least I'll make those profits on the other half of my production. I'm trading risk for certainty.
Global trade also depends on derivatives. Without markets to hedge the risk of fluctuating currency exchange rates, manufacturers and growers would be afraid to accept any currency for their exports other than their own. Without markets to hedge the risk of differing interest rates around the globe, banks and borrowers would be reluctant to transact cross-border loans. Without derivatives, goods, services, and capital would not freely flow across national frontiers. In short, there would be no global marketplace.
Fortunately for the world economy, a handful of true visionaries in Chicago—such as Leo Malamed3 and Richard Sandor4—invented financial futures, swaps, and other derivatives. Fortunately for the United States, these products—so essential to global commerce—are priced in US dollars and remain largely traded in New York and Chicago to this day.
While often derided in the tabloid press as “risky,” derivatives—when used properly—are economically and socially beneficial. More than 90% of Fortune 500 companies use derivatives to manage global risks of varying production costs, such as the price of raw materials, energy, foreign currency, and interest rates.5 In this way, derivatives serve the needs of society to help moderate price and supply to free up capital for economic growth, job creation, and prosperity. It has been estimated that the use of commercial derivatives added 1.1% to the size of the US economy between 2003 and 2012.6
Derivatives make it easier for Americans and American businesses to participate in the growth of our economy. As battered and bedeviled as the American Dream may be these days, it would truly be a myth without swaps. The reason the standard American homeownership tool is a 30-year fixed rate mortgage is because of derivatives. If you think about it, interest rates are not staying flat for 30 years. Interest rates bounce all over the place. But banks are entering into swaps contracts in order to reduce their interest rate risk so they can offer you that fixed rate. Same deal with five-year loans for auto purchases. In Western developed economies, so much of the price and supply stability that we consumers enjoy is provided by these derivative markets.
When you step into your supermarket, do you ever stop and ask: Oh gosh, was it a good harvest this year? Will I have to pick over a few rotten tomatoes? Will there be any bread on the shelves? You do not. You just wander the aisles filling your shopping cart with an abundance of fresh fruit, vegetables, and produce year in and year out. Well, thank derivatives for that.7
In many nations around the world, people do experience those concerns. When there are bad harvests and undeveloped and insecure trading markets, not only are the shelves bare—but there may be no food next year because the farmers will have gone bankrupt.
Food for the Future
As of 2014,8 about 800 million people around the world today were undernourished. That's roughly one in nine of the world's 7.2 billion people—a staggering shortfall. Now consider that there will likely be another two billion people on earth in 30 years.9 Even if those projections are only half accurate, we will have another one billion people on earth by 2048. How will all of these people be fed?
Clearly, the world's agricultural exporting nations, including the United States, will play a big part in feeding the globe in the decades to come. These food exporters can feed an additional billion people because of the critical support of well-functioning financial and derivatives markets. Efficient and well-regulated derivatives markets serve at least two critical roles in helping to feed the world's growing population. First, they allow markets to resolve imbalances dispassionately and efficiently by providing reliable and fair benchmarks for prices. Second, they reduce price volatility in a resource-constrained world by removing the economic incentive to hoard physical supplies. They allow farmers to quantify and transfer risks they want to avoid at a reasonable price to persons willing and able to hold that risk. They help control costs and facilitate return on capital to support essential investment in farming equipment and agricultural technology necessary to meet increased global food demand. Providing farmers this risk protection reduces earnings volatility and thus price volatility, benefiting everyone, including millions of consumers who have never heard of derivatives markets.
The greatest beneficiaries of global derivatives may well be the world's hungriest and most vulnerable. If derivatives trading were ever to suddenly cease, they would certainly suffer the most from the extreme price volatility in basic food and energy commodities that would result.10 In developed economies like the United States, we rarely have to worry about such things thanks to two main types of derivatives. The first type are traded on organized exchanges, like the Chicago Mercantile Exchange, and are called futures or options. The second type are traded in a more negotiated process called “over the counter.” Many of the latter trades are referred to as “swaps,” because two parties agree to exchange cash flows and other financial instruments at specified payment dates during the life of the contract.
I have explained how swaps and other derivatives work so that the reader will later understand their importance in the emergence of Bitcoin and other cryptocurrencies. For now, it's swaps that brings us back to our story.
A Good Long Walk
SEFCON V was set to take place in Manhattan on Wednesday, November 12—just six days after I learned that I would not be permitted to speak there. Hundreds of industry executives and regulators were expected to attend and my colleague CFTC Chairman Tim Massad was giving the luncheon keynote address. I was one of the few Republicans in financial leadership roles who had vocally supported the swaps reforms in Dodd–Frank and, in particular, its mandate that swap
