The risks of modern finance

Why do we need such a vast universe of derivative contracts and synthetic investment vehicles?

Answer because it allows the financial industry to re-circle assets many more times, each time earning a cut of the transaction.   It is not to manage risk: this is the argument that they give you to keep this behemoth, this apocalypse going.

In order to keep earning a return from this universe the cycle needs to a) keep moving and b) keep expanding.  Once the universe contracts, you not only cease to earn a return, but you start to take on the risk of the contracts themselves.  But the damage starts before you cease to earn return, in fact when the rate of growth starts to decline.

The ratio of derivatives is ultimately related to the supply of real underlying assets, and  the absolute incremental increase of the derivative universe needs to keep expanding at a greater rate (relative to the underlying assets) just to keep the rate of growth of return constant.  

The monster takes over the machine!

The universe can collapse even though it is still growing, because it is not growing fast enough to counteract its equilibrating forces.  The risk of such a collapse increases the greater the number of contracts needed to keep the rate of growth of return constant.

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