This blog post calmly examines how derivatives, cloaked in the guise of investment, took on a gambling-like nature. We explore their structure, real-world examples, and the flow of the financial crisis.
Can we pick out the rotten apples?
Finally, let’s look at derivatives. Derivatives refer to ‘financial contracts whose value is determined by fluctuations in the value of underlying financial assets such as currencies, bonds, or stocks’. To understand this, imagine an apple. If you use this apple as raw material to create various products like apple vinegar, apple pie, apple jam, or apple juice, those would be derivatives. Derivatives include forward contracts, futures, options, and swaps.
In reality, the structure of derivatives is highly complex, making it difficult to explain them all, and even when explained, they are not easy to grasp. Therefore, here we will use the relatively easier-to-understand example of ‘futures’ trading to illustrate.
Suppose a farmer is growing apples. The farmer also cannot predict in advance whether this year’s apple harvest will be bountiful or a poor crop. However, a seller proposes to ‘guarantee’ 100 won per apple. If the actual apple price after harvest exceeds 100 won, the farmer incurs a loss; conversely, if it falls below 100 won, the seller who made this proposal suffers the loss. This is fundamentally not significantly different from gambling or speculation, given the inability to predict the future and the reliance on chance outcomes.
Because of this strong speculative nature, derivatives offer very high returns. Derivatives are precisely what can yield tens of millions of won, or even hundreds of millions of won, in profits overnight. Consequently, it’s not uncommon for people who consider themselves somewhat knowledgeable about investing, or those chasing a quick fortune, to jump into derivatives. However, high returns also mean a correspondingly high probability of failure. Some people engage in so-called ‘blind investment’ based solely on the belief that ‘derivatives offer high returns,’ without any real understanding. Yet, no one will shoulder the resulting risks and losses for them.
Derivatives: The Main Culprit of the Financial Crisis
These derivatives are often cited as the main culprit behind the 2008 U.S. financial crisis. Why is that? Lenders created securities representing the right to receive payments from subprime mortgages—loans secured by homes—and sold them to investment banks. But the investment banks didn’t stop there. They created not only products derived from these mortgages but even products designed to hedge against borrowers defaulting, selling them across global markets.
However, as real estate prices fell and the number of people unable to repay their loans surged, subprime mortgages rapidly deteriorated. Since the underlying assets forming the basis of the derivatives became worthless, the collapse of the derivatives built upon them was an inevitable consequence. This is akin to how juice made from rotten apples cannot be fresh or taste good. Ultimately, Bear Stearns and Lehman Brothers, which had directly created and sold these products while undertaking massive investments, could not withstand the enormous losses and went bankrupt.
The problem did not end there. Other derivative products linked to the already impaired derivatives had been widely sold to investors worldwide, including in Europe, India, Brazil, Russia, and Korea. As a result, global financial markets inevitably suffered a chain reaction of paralysis.
An even more shocking event followed. In May 2012, global investment firm JPMorgan publicly admitted it had “incurred losses exceeding $2 billion in just six weeks from derivative investments.” Following this announcement, the U.S. Dow Jones Index fell continuously for a week, plunging over 3%, while South Korea’s stock market also experienced a sharp drop of 7%. Then, in June of the same year, The New York Times reported that the actual loss could be as high as $9 billion, far exceeding the $2 billion disclosed by JPMorgan. This incident, committed by the ‘giant’ that is the United States, which wields the greatest influence on the global economy, continues to leave deep scars on the global financial markets to this day.
Looking at the global derivatives trading volume in 2011, South Korea’s volume reached approximately 3.8 billion transactions, accounting for 27% of the global total and securing the top spot for the third consecutive year. The derivatives market is essentially no different from “selling a mix of good apples and rotten apples together.” In such an environment, the belief that only oneself can pick out the good apples is inherently dangerous. Therefore, the illusion of ‘getting rich quick’ must be discarded immediately.
Attorney Jeon Young-jun of Hanuri Law Firm speaks about the essence of the capital market as follows.
“In the capital markets where financial institutions operate, a single logic reigns supreme: the logic of money. Where else could be more greedy? Financial institutions are structurally bound to be greedy. The problem lies in the extreme complexity of finance. The unfamiliar language of financial engineering often leads to the mistaken belief that anything said by a financial engineer or expert is automatically true and legitimate.”
This is precisely why we must not blindly trust the words of those called financial experts. If we wish to invest in financial products and earn returns, we too must study and cultivate the discernment to see through the hidden traps and underlying aspects of those products. Otherwise, we will be deceived by the ‘experts’, dazzled by the enormous profits presented before us, and ultimately end up losing even more.
