Red-Blooded Risk: The Secret History of Wall Street

Value and Money

But how can derivatives be money when they require money—dollars—for quotation and settlement? This is an excellent question. It's the same question as how can paper be money when it requires gold or silver as a reference value? Even with precious metal coin money we can ask how the value of the coins was set in the first place. You might think that one is easy: It was the value of the metal in alternative use as jewelry or plate. But that's not true; the coin value of gold and silver far exceeded the use value. Once precious metal became monetized, its value divorced from its physical use.

Actually, precious metal money is the hardest one to explain. Paper money has nothing to do with gold, except through misguided regulation. The value of bank-issued paper money is based on the quality of the loans backing it up—in other words, the future goods and services that are guaranteed to be available for purchase by the paper money. Goods and services other than those produced by bank borrowers may be available for purchase, but they can also be withdrawn or sold only if the money is tendered at a discount. To the extent that the bank holds reserve assets, pays interest, is supported by a central bank, or enjoys general confidence, the paper money can have additional value, but its fundamental value is loan value.

How does that relate to government-issued paper money that citizens are forced to accept by legal tender laws? Leaving the laws aside for a moment, the fundamental ...