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Created May 9, 2019 23:35
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Excerpt from Aaron Brown’s “Red-Blooded Risk: The Secret History of Wall Street” (chapter 10) on gold money, paper money, and derivatives

To start a business with precious metal money, you need to have or to find an investor with enough precious metal to buy all the assets you need to start generating cash sales. To start a business with paper money, you need to find a bank willing to supply you with pieces of paper. Neither you nor the bank need have any net worth, although in practice banks tend to maintain net worth equal to a fraction of the loans they make. Even so, the amount of capital required to start the business with paper money lent by a bank is much less than the total value of the assets required. What is essential is that the bank’s lending standards are low enough to approve your loan, but high enough to make its paper money acceptable enough to acquire the assets you need.

To start a business with derivative money, you identify all assets you require and all products you will deliver in the future. Of course, there is uncertainty around these things, especially the amount and quality of products you will deliver. You don’t have to finance the eternal future, just buy enough assets to get you started and sell enough product to cover the cost of the assets you need. You may not be able to find contracts for exactly what you need as inputs and exactly what you expect to deliver as outputs. That’s okay as long as you can find derivatives with a high enough correlation to those things. Since you expect the business to make money, there should be more future value of product than future cost of assets required for production. In your opinion.

This is not theoretical; people are doing it today. The first pure derivative businesses were in the energy sector. (Yes, that includes Enron. But it also includes a lot of other companies, including simple ones.) Someone would decide he wanted to build or buy a power plant. He wouldn’t go to a bank or venture capital fund for the money; he’d go to a derivatives dealer. Our entrepreneur would enter into a contract to receive 10 years of oil supplies to power the plant, plus another contract to sell 10 years of electricity generated by the plant—when these two swaps are combined they are called a “tolling” swap. Since the value of the electricity exceeds the value of oil, he receives cash up front. He uses the cash to buy or build the plant, and to pay other bills like wages and maintenance. At the end of the 10 years, he owns the plant free and clear, his reward for putting the deal together and overseeing successful operation for a decade. If he has failed to operate the plant successfully, he wouldn’t be able to deliver the promised electricity, and the plant would be seized by his derivatives counterparty.

The point that derivatives are the new money is essential for understanding the modern economy.

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