Whenever I hear people talking about cryptocurrencies, much of the conversation always seems to focus on the unsustainability of fiat currency. The common assumption is that the word’s fiat currency system is eventually going to collapse. However, it’s rare to find anyone talking about how that will happen. What issues will drive that collapse, and – perhaps more importantly – how will we be able to recognize it when it’s happening? Because the answers to those questions seem to be so complex, most people don’t ever bother to address them at all. The truth is, though, that the real issues are simple to understand once they’re laid out on the table. This article will attempt to explain some of these complex financial matters in simpler terms to facilitate a greater understanding of the problem at hand.
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With the recent failure of Spanish bank Banco Popular and questions about how Santander could possibly do due diligence on over $150B of assets in under 24 hours, it’s as good a time as any to take note of the real elephant in the room: the banking sector’s Zero Interest Rate Policy, or ZIRP for short. According to the latest BIS figures, the global derivative market now stands at an eye watering $482 Trillion notional. That’s according to BIS tracking (which is about 95~% of global derivatives they monitor). Moreover, the top 4 US banks are holding $147 Trillion notional, according to the OCC, and government debts now total more than $58 Trillion worldwide.
Given that almost all of the world’s central banks currently maintain interest rates at zero, close to zero, or less-than-zero, it makes sense to ask: how is any of this even possible and how does it all end?
The ZIRP Question
While there are many issues related to ZIRP, one of the most critical concerns for the banking sector is the fact that this policy has compressed the margins for traditional banking operations to the point where they are unprofitable in most cases. The problem is simple. When the most that banks can hope for is a one to two-point spread, they’re forced to get creative if they want to maintain shareholder profit and operational cash flow.
Unfortunately, that creativity has led the banking sector to over-leverage its interests just to ensure that it can continue operations with those slim operating margins. That has spawned the modern shadow banking system that we see in the financial world these days. In their pursuit of returns at any cost, banks have leveraged themselves to an extent far beyond the traditional norm for the industry.
When you ask bank economists about these huge derivative exposure numbers, their first response is almost always, “Gross is not net. These numbers represent total notional value, not the net value – which is much lower.” On the surface, this is certainly true. Until it isn’t. You’ll also hear bank spokesmen suggesting something along the lines of, “We have bilateral netting which almost entirely eliminates net exposure.” That too seems to be true. However, all these explanations omit the one question you need to ask whenever any trade is at issue: who’s on the other side of that transaction?
The real problem with this entire system can be traced to the underlying assumption of bilateral netting. That assumption presumes that when collapse or failure occurs, all contracts will be honored by the issuer. Sadly, however, we know that this assumption is not true – and anyone who remembers the fallout from AIG and Lehman nearly a decade ago should understand why. In AIG’s case, the insurer was teetering on the verge of imploding, which would have rendered trillions of dollars in contracts worthless. That didn’t happen, of course, but only because the political class was so horrified at the prospect of bankers losing money that Washington D.C. used billions of dollars of taxpayer money to bail them out. Of course, few seem to remember those days of peril now, since the financial world’s attention span seems to extend no further than about a week. Anything that happened ten years ago is easily forgotten – as though it never happened at all.
Of course, we’re told that there’s nothing to worry about, since bankruptcy rules will ensure that senior creditor status is given to help make contract signers whole – or as close to whole as possible – in the event of failure. You don’t have to be well-versed in bankruptcy laws or procedures to recognize just how unlikely that would actually be in the event of a real collapse. I have serious doubts about whether they would even obtain the senior creditor status they might be expecting, though that would probably depend on the individual contracts in question. Even if they do, however, the bankruptcy process might only provide them with 5-10 cents on the dollar. And that’s if they’re extremely fortunate. Now, some will say that you can obtain protection to hedge that downside, but that begs the question: who do you purchase that protection from, and where does the money come from to make those payouts in the event of a collapse scenario?
That leads to another question: what methods do banks use to hedge the downside risks of those types of events? As it turns out, they purchase CDS contracts (Credit Default Swaps) on the default event of the issuer. The problem is that this puts even greater pressure on the strongest links in the chain. In an effort to mitigate individual risk, these purchases over-leverage the entire system and increase the likelihood of a systemwide collapse. Why? Because if everyone is purchasing protection against downside risk from one another, who will be there to pay out if everything collapses?
Think of it this way: you have three people in a room, and each of them owes the others one million dollars. That would mean that the entire room has a collective three million dollars’ worth of debt. On the surface, each of them is a millionaire, though none of them has a penny to show for that wealth. That type of scenario is how the book values of these banks appear, which is why Deutsche Bank (with its $40 trillion in notational derivatives) can almost implode due to its razor-thin operating capital.
Now imagine if everyone in that room owes the others $10 trillion. What happens if one of them ends up in a situation where he can no longer pay to roll over the contracts – as happened with Leheman almost a decade ago? This is an important question to ponder, since it isn’t a question of whether that will ever happen, but when. Fiat currency’s inherent unsustainability makes that outcome a certainty. Moreover, since the entire system is underwritten by just a handful of institutions, what’s the end result when counter-parties can no longer pay on those contracts? What happens in this game of musical chairs when the melody suddenly stops and there are no chairs to be found?
Has the Risk Diminished?
Some might be tempted to point to the deleveraging that’s been in the works for a number of years now – an effort that’s seen that number decline from almost $700T to just under $500T. The problem is that the underlying danger continues to place the entire system at risk. Bank failures like Banco Popular and national crises like those in Greece and other troubled eurozone nations are like a terminal illness that never goes away. Deutsche Bank. Collateral issues. Basel requirements. The fundamental problem continues to lie just beneath the surface of what most people see when they look at the world’s financial system.
Now, here’s the real kicker: with bank profits at stake, we are faced with the very real risk that we may soon witness the biggest margin call that the world has ever seen. Only it won’t be coming from any broker. Instead, it will simply be a fission reaction erupting from the financial system itself.
It doesn’t matter what sell-side analysts say. When the bilateral netting chain eventually breaks, this whole house of cards will come crashing down. The existing contracts will stop generating book value cash flow streams for the counterparties, and the shock waves will ripple out until the entire credit pyramid collapses in on itself. At that point, the banking and shadow banking system will be forced to deliver itself, either through inflation or bankruptcy. Unlike the financial crisis of 2008, this eventual collapse cannot be escaped. The numbers and the problem are simply too large for taxpayers to handle.
Meanwhile, everyone will continue to tell you to not worry about the gross number and instead focus on the net. That is, until we all come to the realization that the gross becomes net just as soon as that thin thread of bilateral netting breaks. The truly frightening thing is that it only takes one part of that thread to fray, since the entire system is so overleveraged due to ZIRP and the banks’ pursuit of returns. Right now, the thing that keeps the entire scheme intact is the assumption that there is no real counterparty risk.
When the Levee Breaks...
Of course, that can only last for as long as people continue to believe that taxpayer-backed banks can never fail. But what happens when taxpayers realize that they’re paying for that solvency via inflation, just to ensure that the banks don’t lose money? The answer is clear, and it’s something that we in the West haven’t considered or experienced on any type of mass scale for generations.
Few people right now are even asking the right question: how long can this continue? In my analysis, it would seem that this current state of affairs is likely to get worse – and soon. As it worsens, the value of that total derivative market will sharply decline, net value will decrease, and notional value will rise. The latter should serve as the proverbial canary in a coal mine, because it will serve as an early warning that the banks are actively working to maintain profitability in their ZIRP environment.
They will have no other choice, since today’s banks can no longer operate as functional banking institutions. Instrument like currency swaps are one of the most efficient ways for them to leverage their cash flow to maintain any semblance of bank profits. And with the taxpayers ultimately positioned to serve as their underwriters, there is no incentive for them to worry about counterparty risk, macro risk, or even long-term sustainability. It’s a casino, but not the type most gamblers get to enjoy. At this casino, the banks win when they win, and the taxpayers reimburse them when they lose. Until the losses are so great that no one can afford to cover them.
And that’s how trillions of dollars can ultimately disappear. When the levee finally breaks, the cold waters of reality could just wash the entire system away - like a magic trick, but without the entertaining show, attractive assistant, or thunderous applause.