What are derivatives? The Chinese explanation

It is no secret that China is a relative newcomer to the world of modern investing. Thus, it is somewhat surprising that the clearest and most coherent explanation of derivatives I have ever heard comes from a gentleman called Gao Xiqing.

Gao Xiqing is the President of the China Investment Corporation (China's sovereign wealth fund managing USD $250 billion). The following article is an extraction of a very candid interview with the Atlantic appearing in the December of 2008 issue. In his presentation to the Chinese State Council in either 1999 or 2000, including Premier Zhu Rongji, Gao was faced with having to explain derivatives with government officials with little or no background in finance.

"If you look at every one of these [derivative] products, they make sense. But in aggregate, they are bullshit. They are crap. They serve to cheat people... So I wondered, How do I explain derivatives?, and I used the model of mirrors.

First of all, you have this book to sell. [He picks up a leather-bound book.] This is worth something, because of all the labor and so on you put in it. But then someone says, “I don’t have to sell the book itself! I have a mirror, and I can sell the mirror image of the book!” Okay. That’s a stock certificate. And then someone else says, “I have another mirror—I can sell a mirror image of that mirror.” Derivatives. That’s fine too, for a while. Then you have 10,000 mirrors, and the image is almost perfect. People start to believe that these mirrors are almost the real thing. But at some point, the image is interrupted. And all the rest will go.

When I told the State Council about the mirrors, they all started laughing. “How can you sell a mirror image! Won’t there be distortion?” But this is what happened with the American economy, and it will be a long and painful process to come down.

I think we should do an overhaul and say, “Let’s get rid of 90 percent of the derivatives.” Of course, that’s going to be very unpopular, because many people will lose jobs."

It appears that Warren Buffett, who has in the past referred to derivatives as "financial weapons of mass destruction", would be in complete agreement. He discusses and criticizes derivatives extensively in his 2002 letter to Berkshire Hathaway shareholders. An excellent summary of that can be found here.