Before the 1980s banking and financial trading were based on relationships. Bankers and Stockbrokers knew their clients personally, success in their professions depended critically on sound judgement and good reputations, which were guarded and nurtured by exercising caution and providing carefully considered advice. It was a time when integrity and trust were the bedrock of the sector. Today things are very different. Anonymous markets have replaced personal relationships, finance is dominated by trading, and trading is a principal source of revenue and remuneration. Fifty years ago the average length of time that a company share was held was seven years, today, thanks to computerised high frequency trading, it is twenty-two seconds.[209]
The changes accelerated after 1980 because of extensive deregulation, and increased the sector's turnover and profitability dramatically - a process known as financialisation. However the changes had little to do with the real needs of the economy. Those needs remain the same now as earlier - payment processing; credit; management of personal finances; and management of risk (Kay 2015 p18). However changes were taking place before that in the early 1970s following the US's abandonment of the international gold standard in 1971. That killed off the Bretton Woods agreement that had been reached in 1944 in the last years of the Second World War, and ushered in floating exchange rates. Details of these events and their wider implications are covered in Part 3. This triggered the explosion in derivative trading, which now dwarfs world trade in non-financial goods and services.
Derivatives are financial products whose value is derived from some other financial or non-financial product, and some have been around for a long time. For example futures contracts for agricultural produce allow farmers to agree today a price for produce that will not be available for several months, thereby relieving them of risks associated with later price fluctuations. In effect they provide insurance against price drops, but at the cost of missing out on possible price rises. Farmers value these products because they can plan for the future rather than having to gamble on it.
When floating exchange rates came about so did associated risks due to exchange rate fluctuations, which exporters and importers preferred to avoid, so contracts in foreign exchange futures became popular. Options are another form of derivative contract with a long history. These give the holder the option, but not the obligation, to buy or sell a particular commodity or stock at a given price at a given time in the future. Like futures contracts, option contracts are themselves tradable at any time before they expire, and markets exist for the purpose.
The range of derivatives has mushroomed in recent years, now not only providing insurance against future risks, but access to otherwise hard-to-trade assets such as commodities, products designed to take advantage of tax rules, and products of largely speculative interest.[210] Some of the more common derivatives include forwards, futures, options, swaps, and variations on these such as synthetic collateralised debt obligations (don't ask!) and credit default swaps. All are tradable and speculation in them is rife. Derivatives form one of the three main types of financial asset, the others being equity (company shares) and debt (bonds, mortgages etc.). Much of the growth in the financial sector since 1980 has been the direct and indirect consequence of the growth in derivatives markets (Kay 2015 p19). Banks and associated financial companies create derivatives and collect fees when people trade them, and banks lend money to those who want to carry out those trades, so they are hugely profitable for the banking and financial trading sector, and this is why they have expanded so dramatically since deregulation.
Derivatives also increase the level of complexity and integration in the financial world. We have already seen that banks, financial trading companies and insurance companies have become ever more tightly bound together, not only with each other under global parent corporations but also between each other by an interconnecting web of debt contracts. Derivatives extend the complexity and integration further by binding financial products together. In worrying about financial crises it isn't the size of individual companies that poses the problem - expressed as 'too big to fail' - it's the degree of coupling between them, where the tighter the coupling the more they act as a single company and the more likely they are to fail together.
Trying to limit the risk of financial crises by making individual banks and financial companies smaller, when they are all tightly coupled together, is like trying to limit the crash risk to train passengers by making individual carriages smaller.
The derivatives market is enormous, estimated in 2015 to be $1,200 trillion[211], which is more than ten times world GDP. There are several reasons. Firstly the same assets might be involved in several different derivatives so they are counted multiple times; secondly many derivatives are hard to value accurately so for simplicity they are valued at the underlying asset value; and thirdly because derivatives are often used to hedge risks there's a good chance that many contracts cancel one another out.[212]