As ever, a great article by John Lanchester in the LRB. I never really understood how things like derivatives and hedge funds worked until I read this.
In fact, I didn't wholly appreciate how banks worked either:
"Imagine a country with only one bank. A customer goes into the bank and deposits £200. Now the bank has £200 to invest, so it goes out and buys some shares with the money: not the full £200, but the amount minus the percentage which it deems prudent to keep in cash, just in case any depositors come and make a withdrawal. That amount, called the 'cash ratio', is set by government: in this example let's say it's 20 per cent. So our bank goes out and buys £160 of shares from, say, LRB Ltd. Then LRB goes and deposits its £160 in the bank; the bank now has £360 of deposits, of which it needs to keep only 20 per cent – £72 – in cash. So now it can go out and buy another £128 of shares in LRB, raising its total holding in LRB Ltd to £288. Once again, LRB Ltd goes and deposits the money in the bank, which goes out again and buys more shares, and so on the process goes. The only thing imposing a limit is the need to keep 20 per cent in cash, so the depositing-and-buying cycle ends when the bank has £200 in cash – all the cash there is – and £800 in LRB shares; it also has £1000 of customer deposits, the initial £200 plus all the money from the share transactions. The initial £200 has generated a balance sheet of £1000 in assets and £1000 in liabilities. Magic! In real life, it's even better: the UK cash ratio is 0.15 per cent, so that initial £200 would generate £133,333 on both sides of the balance sheet."