Derivatives – A Recipe for Disaster?

Gambling according to Wikipedia is the wagering of money (or something of value) on an event with an uncertain outcome. Three elements are required for gambling -consideration, chance, and prize. Gambling dates back 3000 years. The first well known casino was set up in Venice in the early 1600s.

Casino means a small house and the house was the banker. The odds were naturally always in favour of the house and that has not changed for centuries. In the last 100 years, the bankers or the House have made fortunes and especially in the last 25 years as market manipulation has taken massive proportions.

Over the last 100 years, governments and central bankers have made the investment markets into a casino with only winners which primarily have been the bankers themselves.

According to Egon von Greyerz, central and commercial bankers have created the most perfect Casino model, a model where the banker is the winner every time. Firstly, the banker issues the money with the help of infinite leverage. Then he sets the conditions – interest rates, fees, terms etc. To further improve his odds, the banker also moves markets so that they are always in his favour.

The most perfect market from the bankers’ point of view is the derivative market. It consists primarily of unregulated Over the Counter (OTC) instruments. A derivative is an instrument which derives its value from underlying assets such as stocks, stock indices, bonds, foreign exchange, gold, silver etc.

The system is skewed against the buyers of the derivatives. Prices are set so that the issuer of the derivative cashes in virtually every time. Prices are always set for the bank to collect bulk of the premium.

 It is important to understand that the value of a derivative is derived from underlying assets but there is absolutely nothing backing a derivative except for the credit standing of the issuer.

According to BIS, the  total notional amounts outstanding for contracts in the derivatives market is an estimated USD542.4 trillion. But the gross market value of all contracts is much lower at USD12.7 trillion. By any calculation it is a sizeable market.

Financial regulators have done some reforms since 2008 but a lot is still unfinished. Globally, at least 37% of all credit derivative transactions go through central computers. But what happens in a crisis?

Cleaning houses can go from sources of stability to conduits of a contagion. Do they have ample resources? Evidence is not encouraging. The thin layer of equity is not sufficient. To do their job they need capacity to absorb losses. Then, regulators must conduct public stress tests just as they do for large banks. Markets need confidence that clearing houses can weather a perfect storm!

Reference:

1. Derivatives-a recipe for disaster & systemic collapse, Egon von Greyerz, March 15, 2018

2. Derivatives are still too dangerous, Editorial Board, Bloomberg, April 10, 2019-06-20

3. Decade after crisis, a $600 trillion market remains murky to regulators, Emily Flitter, Nytimes.com