Derivatives as Money

Throughout this financial crisis , intellectuals have struggled to re-define our understanding of money. To understand currencies, one must investigate how money is used as reserves (to deal with the redux bank run issues), debt based money mechanics systems, and the new financial securitization innovations over the past 20 years, including securitized debt (for example CDOs), and their financial grease: derivatives (credit default, interest rate, and currency swaps).

The Liquidity Pyramid
Much speculation lately focuses not so much on what the stock market will do (the answer to that should be self-evident, especially once shorting stocks again becomes a practical reality), but what the impact of recent economic policies will be not just on inflation (regional or global), but also on that most sacrosanct piece of paper, the U.S. dollar.

In order to approach this question from a different angle than the conventional theoretical wisdom of Quantitative Easing being the end all be all explanation for the mid- and long-term fate of the U.S. currency, an approach that has much more practical credence is that presented by David Roche of Independent Strategy, which demonstrates overall liquidity, defined as claims on goods, services and assets, as an inverted pyramid.



At the bottom of this pyramid is the power money of reserve cash - liquidity created on the balance sheet of central banks. As noted, it accounts for a mere 1% of global liquidity, and thus the impact that the Fed and other world central banks will have with existing policies that address merely this aspect of liquidity will be, at best, massively muted. Above this is the liquidity bank loans liquidity, created through the conventional credit multiplier mechanism of commercial banks. Above that still is the liquidity created by securitization of debt. This experiment, gone horribly wrong, allowed claims on illiquid assets to grow further relative to the reserve money in the system. This is precisely the layer that the Fed and Treasury are trying to revive with the various TALF iterations, so far unsuccessfully. And at the very top of the pyramid is the layer of interest rate and credit derivatives: a means whereby institutions were able to maximize claims on physical and financial assets, by insuring against losses, without increasing precautionary reserves either of capital or reserve money.

In order to fully understand currency and price movements, one has to realize that the securitization of debt, and creation of derivatives amounted to a huge virtual printing press, primarily fueled by a massive increase in risk appetite which allowed for a huge expansion in the value of claims on financial assets and goods and services. It is worth pointing out, that the Fed has little to no control over this "printing press" at this point, which at last count was responsible for over 90% of the liquidity in the system.

Show me the money

In a fiat currency system, as previously pointed out, money is nothing more than a claim on assets, goods and services, and, most dangerously, money created at the top of the pyramid, in electronic form or otherwise, is just as real as the coins and physical dollars held at the basement of the Federal Reserve. The propagation of money higher in the liquidity pyramid explains why all traditional measures of money supply are not only inadequate but likely flawed: orthodox measure of money supply only include the first two pyramid tiers and completely ignore the major ones at the top. This is a major problem as analysts and economists who rely on these traditional "money metrics" only get a glimpse of 7% of the global liquidity in circulation. As for the the balance? The effect of creating an overabundant supply of money (that was not figuring into any monetarist policies) was that the price of money fell relative to assets, commodities and goods, services and labor. Therefore not only did generalized price inflation accelerate, but so did the increase in asset prices as well as the 6 year commodity bull run over the past 6 years.

The comments on this subject are a lively discussion on how to define money supplies. Considering that derivative securities are often treated as equivalent to money (for example, the notional value of derivatives are recorded on balance sheets), I tend to think this author is on the right track for understanding the mega topics of inflation and deflation.

Modern finance is largely about translating value from one medium to another, and if you want to touch all the parts of the world financial elephant, including how people treat securitized assets is crucial.