The myth of virtuality
July 12, 2007
Increasingly, I hear and read in academic forums about the ‘virtuality’ of derivative markets. The notion that these markets are ‘not-real’, disjointed or otherwise exist ‘outside economy’ is raised frequently in sociological papers. This notion is also accompanied, more times than not, by the would-be implications of that ‘virtuality’. That is: what can derivative markets do because they are ‘virtual’? For example, derivatives and liquidity. A few months ago I listened to a paper in which the author claimed that because derivatives can be written on the basis of anything, are written for a very large variety of underpinning assets that can be exchanged, derivative markets provide, in effect, an almost infinite liquidity!
Another area affected by the ‘virtuality’ syndrome is the concept of leverage. Many derivatives allow high leverage and, consequently, there is a high ratio between the volume of derivatives contracts traded (nominal value) and contracts that get exercised (exchanged for the underpinning asset). The common argument following this characteristic of derivatives goes along these lines: “the annual nominal value of exchange-traded derivatives exceeds the global GDP [so far so good] and therefore it is obvious that these markets are completely divorced from any normal economic activity and are responsible for the hyper-capitalism we currently witness, the widening gap between rich and poor …” You get the drift.
True, the nominal value of derivatives traded is indeed astronomical and it is true that only a fraction of that volume is exercised. Additionally, it would be fair to say that the operation of many derivatives markets is hinged upon maintaining such a condition. However, does this fact make derivatives markets virtual? Let me put it differently. If the high ratio between held contracts (or even assets) and exercised assets is a mark of a virtual market then one does not need to delve into the exotic world of swaps, binary options and other financial beasts to find ‘virtual’ markets. In fact, to find them, it is enough to look at the boring, old stock exchange. On a extremely busy day in the New York Stock Exchange only between 1.5 and 2.0 per-cent of the Dow Jones Industrial Index stocks held by the public change hands. Yet, this minute amount determines a price change for the rest of un-traded bulk of stocks. Moreover, the validity of the price quoted for stocks is conditioned on the very fact that only a relatively small minority of owners would want to trade them at any given moment. If, for example, one morning 90% of the owners of IBM shares would decide to sell them, it is fairly obvious that the large majority among them would not receive a price that is even close to the price quoted for IBM the previous day… So, we see that the stock market, very much like the dreaded derivatives market is based on a high ratio between exercised and held assets. Well, then, is the stock market also ‘virtual’.
An even more ‘basic’ example for the same phenomenon is commercial banks’ reserve ratio. All sociology textbooks refer to the self-fulfilling nature of ‘run on the bank’: a bank’s customers, believing that there may be a liquidity problem with the bank, withdraw their savings and thereby cause a liquidity problem. But, let us now examine the common situation in which the cash-to-loans ratio is kept. It is obvious that not all the deposits are readily available in the bank, the same way that not all stocks can be exchanged simultaneously and not all derivatives can be exercised. So, does this make all there institutions virtual? Following the logic of the hypothetical (but sadly, very realistic) quote presented above, the answer must be: yes. All financial markets include such an inherent ‘virtual’ element. So, does this mean that there are no distinguishing factors that make derivatives markets worthy of a focused sociological analysis? Certainly not; it only means that if we want to talk sociologically about derivatives markets, we may have to discard the false concept of ‘virtuality.