Hyperinflation is Coming - The Dollar Endgame

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Indexes
  1. The Global Monetary System — A New Rome
  2. Prologue:
  3. US Trade Balance
  4. US Gold Reserves
  5. MONKE-SPEK: Philips Curve Explained
  6. Smooth Brain Overview:
  7. The Ouroboros — The Dollar Endgame
  8. Prologue:
  9. Random Walks and Portfolio Insurance
  10. Derivatives and the Alchemy of Risk
  11. Nitroglycerin

The United States has been abusing it’s economic privilege as the World Reserve Currency by creating artificial demand for treasuries and US Dollars.

By Peruvian Bull

TL/DR: Economists are getting worried about the increasing number of hyperinflation signals flashing red with some believing the process has already begun [1]. The first stages of hyperinflation are slow and as an exponential process, most people will not grasp the true extent of it until it is too late.

We are at the end of a MASSIVE debt supercycle [2]. This 80–100 year pattern always ends in one of two scenarios- default/restructuring (deflation a la Great Depression) or inflation( hyperinflation in severe cases (a la Weimar Republic). The United States has been abusing it’s privilege as the World Reserve Currency holder to enforce its political and economic hegemony onto the Third World, specifically by creating massive artificial demand for treasuries/US Dollars, allowing the US to borrow extraordinary amounts of money at extremely low rates for decades, creating a Sword of Damocles [3] that hangs over the global financial system.

The massive debt loads have been transferred worldwide and sovereigns are starting to call our bluff. Systemic risk within the US financial system (from derivatives) has built up to the point that collapse is all but inevitable and the Federal Reserve has demonstrated it will do whatever it takes to defend legacy finance and government solvency, even at the expense of The US Dollar.

PART 1

The Global Monetary System — A New Rome

Some terms you need to know:

Inflation: Commonly refers to an increase in prices (per Keynesian thinking). However, Inflation in the truest sense is inflation (growth) of the money supply- higher prices are just the RESULT of monetary inflation. (Think, in normal terms, prices really only rise/fall, same with temperatures. (ie Housing prices rose today). The word Inflation refers to a growth in multiple directions (quantity and velocity). Deflation means a contraction of the money supply, which results in falling prices.

Dollarization: (Weaponization of the Dollar): The process by which the US government, IMF, World Bank, and other elite organizations force countries to adopt dollar systems and therefore create indirect demand for dollars, supporting its value. (Think Petrodollars).

Central Banks: Generally these are banks that control/monitor the monetary policy of the country they reside in. They are usually owned by private financial institutions (large banks/bank holding firms). They utilize open market operations to stabilize and set market rates. They are called the “Lender of Last Resort” as they are supposed to LEND (not bailout/buy assets) to other banks in a crisis and help defend their currency’s value in international forex markets. CBs are beholden to the “dual mandate” of maintaining price stability (low inflation) and a strong job market (low unemployment)

Monetary Policy: The set of tools that central bankers have to adjust how money moves through the financial system. The main tool they use is quantitative tightening/easing, which basically means selling treasuries or buying treasuries, respectively. *A quick note- bond prices and interest rates move inversely to one another, so when Central banks buy bonds (easing), they lower interest rates; and when they sell bonds (tightening), they increase interest rates.

Fiscal Policy: The actions taken by the government (mainly spending and taxing) to influence macroeconomic conditions. Fiscal policy and monetary policy are supposed to be enacted independently, so as not to allow massive mismanagement of the money supply to lead to extreme conditions (aka high inflation/hyperinflation or deflation) *cough Yellen cough*

Allegory of the Prisoner’s Dilemma

Prologue:

In their masterwork tapestry entitled “Allegory of the Prisoner’s Dilemma” (pictured in the title image of this post) the artists Diaz Hope and Roth visually depict a great tower of civilization that rests upon a bedrock of human cooperation and competition across history. The artists force us to confront the fact that after 10,000 years of human civilization we are now at a cross-roads. Today we have the highest living standards in human history that co-exists with an ability to destroy our planet ecologically and ourselves through nuclear war.

We are in the greatest period of stability with the largest probabilistic tail risk ever. The majority of Americans have lived their entire lives without ever experiencing a direct war and this is, by all accounts, rare in the history of humankind. Does this mean we are safe? Or does the risk exist in some other form, transmuted and changed by time and space, unseen by most political pundits who brazenly tout perpetual American dominance across our screens? (Pulled from Artemis Capital Research Paper)

The Bretton Woods Agreement

Money, in and of itself, might have actual value; it can be a shell, a metal coin, or a piece of paper. Its value depends on the importance that people place on it — traditionally, money functions as a medium of exchange, a unit of measurement, and a storehouse for wealth (what is called the three factor definition of money). Money allows people to trade goods and services indirectly, it helps communicate the price of goods (prices written in dollar and cents correspond to a numerical amount in your possession, i.e. in your pocket, purse, or wallet), and it provides individuals with a way to store their wealth in the long-term.

Since the inception of world trade, merchants have attempted to use a single form of money for international settlement. In the 1500s-1700s, the Spanish silver peso (where we derive the $ sign) was the standard- by the 1800s and early 1900s, the British rose to prominence and the Pound (under a gold standard) became the de facto world reserve currency, helping to boost the UK’s military and economic dominance over much of the world. After World War 1, geopolitical power started to shift to the US, and this was cemented in 1944 at Bretton Woods, where the US was designated as the WRC (World Reserve Currency) holder.

Bretton Woods

In the early fall of 1939, the world had watched in horror as the German blitzkrieg raced through Poland, and combined with a simultaneous Russian invasion, had conquered the entire territory in 35 days. This was no easy task, as the Polish army numbered more than 1,500,000 men, and was thought by military tacticians to be a tough adversary, even for the industrious German war machine. As WWII continued to heat up and country after country fell to the German onslaught, European countries, fretting over possible invasions of their countries and annexation of their gold, started sending massive amounts of their Gold Reserves to the US. At one point, the Federal Reserve held over 50% of all above-ground reserves in the world.

US Trade Balance

In a global monetary system restrained by a Gold Standard, countries HAVE to have gold reserves in their vaults in order to issue paper currency. The Western European powers all exited the Gold standard via executive acts during the dark days of the Great Depression (in Germany’s case, immediately after WW1) and build up to War by their respective finance ministers, but the understanding was they would return back to the Gold standard, or at least some form of it, after the chaos had subsided.

As the war wound down, and it became clear that the Allies would win, the Western Powers understood that they would need to come to a new consensus on the creation of a new global monetary and economic system.

Britain, the previous world superpower, was marred by the war and had seen most of her industrial cities in ruin from the Blitz. France was basically in tatters, with most industrial infrastructure completely obliterated by German and American shelling during various points of the war. The leaders of the Western world looked ahead to a long road of rebuilding and recovery. The new threat of the USSR loomed heavy on the horizon, as the Iron Curtain was already taking shape within the territories re-conquered by the hordes of Red Army.

Realizing that it was unsafe to send the gold back from the US, they understood that a post-war economic system would need a new World Reserve Currency. The US was the de-facto choice as it had massive reserves and huge lending capacity due to its untouched infrastructure and incredibly productive economy.

At Bretton Woods, the consortium of nations assented to an agreement whereby the Dollar would become the WRC and the participating nations would synchronize monetary policy to avoid competitive devaluation. In summary, they could still redeem dollars for Gold at a fixed rate of $35 an oz, a hard redemption peg which the U.S would defend.

Thus they entered into a quasi- Gold standard, where citizens and private corporations could NOT redeem dollars for Gold (due to the Gold Reserve Act , c. 1934), but sovereign governments (Central banks) could still redeem dollars for gold. Since their currencies (like the Franc and Pound) were pegged to the Dollar, and the Dollar pegged to gold, all countries remained connected indirectly to a gold standard, stabilizing their currency conversion rate to each other and limiting local governments’ ability to print and spend recklessly.

US Gold Reserves

For a few decades, this system worked well enough. US economic growth spurred European rebuilding, and world trade continued to increase. Cracks started to appear during the Guns and Butter era of the 1960’s, when Vietnam War spending and Johnson’s Great Society programs spurred a new era of fiscal profligacy. The US started borrowing massively, and dollars in the form of Treasuries started stacking up in foreign Central Banks reserve accounts.

Then-French President Charles De Gaulle did the calculus and realized in 1965 that the US had issued far too many dollars, even considering the massive gold reserves they had, to ever redeem all dollars for gold (remember naked shorting more shares than exist? -same idea here). He laid out this argument in his infamous Criterion Speech and began aggressively redeeming dollars for gold.

The global “run on the dollar” had already begun, but the process accelerated after his seminal address, as every large sovereign turned in their dollars for bullion, and the US Treasury was forced to start massively exporting gold. Backing the sovereign government’s actions were fiscal and monetary strategists getting more and more worried that the US would not have enough gold to redeem their dollars, and they would be left holding a bag of worthless paper dollars, backed by nothing but promises. The outward flow of gold quickly became a deluge, and policymakers at all levels of Treasury and the State Department started to worry.

Nixon ends Bretton Woods

Nearing a coming dollar solvency crisis, Richard Nixon announced on August 15th, 1971 that he was closing the gold window, effectively barring all countries from current and future gold redemptions. Money ceased to be based on the gold in the Treasury vaults, and instead was now completely unbacked, based solely on government decree, or fiat. Fixed wage and price controls were created, inflation skyrocketed, and unemployment spiked.

Nixon’s speech was not received as well internationally as it was in the United States. Many in the international community interpreted Nixon’s plan as a unilateral act. In response, the Group of Ten (G-10) industrialized democracies decided on new exchange rates that centered on a devalued dollar in what became known as the Smithsonian Agreement. That plan went into effect in Dec. 1971, but it proved unsuccessful. Beginning in Feb. 1973, speculative market pressure caused the USD to devalue and led to a series of exchange parities.

Amid still-heavy pressure on the dollar in March of that year, the G–10 implemented a strategy that called for six European members to tie their currencies together and jointly float them against the dollar. That decision essentially brought an end to the fixed exchange rate system established by Bretton Woods. This crisis came to be known as the “Nixon Shock” and the DXY (US dollar index) began to fall in global markets.

DXY Since 1973

This crisis came out of the blue for most members of the administration. According to Keynesian economists, stagflation was literally impossible, as it was a violation of the Philips Curve principle, where Unemployment and Inflation were inversely correlated, thus inflation should theoretically be decreasing as the recession worsened and unemployment climbed through 1973–1975.

Phillips Curve

MONKE-SPEK: Philips Curve Explained

  • Low Unemployment>Lots of jobs/high demand for labor.
  • Thus, more workers are employed, and wages rise>putting more money in more people’s pockets.
  • These people go out and buy beanie babies, toasters, and bananas (what economist John Maynard Keynes called aggregate demand) and this higher demand lead to higher prices for goods and services. This shows up as inflation.
  • Consider the opposite- high unemployment>fewer jobs>less money for people
  • Less demand for goods and services> lower inflation

Keynesian economists treated this curve as a law of nature, rather than a general rule. We see exceptions to this rule everywhere- Argentina is a prime example, where they have persistently high unemployment AND high inflation. This phenomenon is called stagflation, and is evidence of inflationary pressures so strong that they overcome the deflationary force of high unemployment. These economists were utterly blindsided by the emergence of stagflation.

After the closing of the gold window in 1971, the crisis spread, inflation kept climbing, and other sovereigns began contemplating devaluing their currencies as their only peg, the US dollar, was now unmoored and looked to be heading to disaster.

US exports started climbing (cheaper dollar, foreigners could now import stuff to their countries), straining export economies and sparking talks of a currency war. Knowing they had to do something to stop the bleeding, the Nixon administration, at the direction of Henry Kissinger, made a secret deal with OPEC, creating what is now called the Petrodollar system. This article summarizes it best:

PetroDollar system

PetroDollar system

Petrodollars had been around since the late 1940s, but only with a few suppliers. Petrodollars are U.S. dollars paid to an oil-exporting country for the sale of the commodity. Put simply, the petrodollar system is an exchange of oil for U.S. dollars between countries that buy oil and those that produce it.

By forcing the majority of the oil producers in the world to price contracts in dollars, it created artificial demand for dollars, helping to support US dollar value on foreign exchange markets. The petrodollar system creates surpluses for oil producers, which lead to large U.S. dollar reserves for oil exporters, which need to be recycled, meaning they can be channeled into loans or direct investment back in the United States.

It still wasn’t enough. Inflation, like many things, had inertia, and the oil shocks caused by the Yom Kippur War and other geo-political events continued to strain the economy through the 1970’s.

PCE Index

Running out of road, monetary policymakers finally decided to employ the nuclear option. Paul Volcker, the new Federal Reserve Chairman selected in 1979, knew that it was imperative to break the back of inflation to preserve the global economic system. That year, inflation was spiking well above 10%, with no end in sight. He decided to do something about it.

Volcker Doctrine

By hiking interest rates aggressively, consumer credit lending slowed, mortgages became more expensive to finance, and corporate debt became more expensive to borrow. Foreign companies that had been dumping US dollar holdings as inflation had risen now had good reason to keep their funds vested in US accounts. When the Petrodollar system, which had started taking shape in ’73 was completed in March 1979 under the US-Saudi Joint Commission, the dollar finally began to stabilize. The worst of the crisis was over.

Volcker had to keep interest rates elevated well above 8% for most of the decade, to shore up support for the dollar and assure foreign creditors that the Fed would do whatever it takes to defend the value of the dollar in the future. These absurdly high interest rates put a brake to US government borrowing, at least for a few years. Foreign creditors breathed a sigh of relief as they saw that the Fed would go to extreme lengths to preserve the value of the dollar and ensure that Treasury bonds paid back their principal + interest in real terms.

10yr US treasury yields

Over the next 40 years, the United States and most of the developed world saw a prolonged period of economic growth and global trade. Fiat money became the norm, and creditors accepted the new paradigm, with its new risk of inflation/devaluation (under the gold standard, current account deficits, and thus inflation risk, was self-stabilizing). The Global Monetary system now consisted of free-floating fiat currencies, liberated from the fetters of the gold system.

Dollar Hegemony

Ok, let’s go over this for a second. Let us say you are the President of a country like Liberia, a small West African nation, looking to enter global trade. You go talk to the International Monetary Fund, whose economists tell you in order to be a modern economy you need to have your own currency. Thus, you need a Central Bank to print your own currency (LD), which will be used as legal tender, enforced by your government. Your Central bank will act as a lender of last resort for all the commercial and investment banks in your country and will be responsible for stabilizing monetary policy.

But, there’s an issue-the economists tell you that you CANNOT have your Central Bank store up your own currency as the majority of its foreign exchange reserves. Why? Well, if your currency comes under attack in the global Forex markets, you will have to defend it. If your currency trade value is too high, it’s easy to fight- you just print your own currency and buy Euros (EU) or Dollars (USD), flooding the market with your currency and taking other currencies out of the market- “devaluing your currency” .

However, if the inverse is true, and your currency is losing value in the market, printing more to flood the market will only make it worse. You need a stable currency, like bullets in the chamber, to utilize to buy your currency at the market rate, to support its value and drive it back up. This form of currency defense is called “defending the peg” (Post-1971, the peg is floating, so it’s more of a range, but it’s still referred to loosely as a peg).

This exact phenomenon played out during the Asian Financial Crisis of 1997, a classic case study in global monetary crises. Thailand had grown rapidly as world trade boomed in the 1980s and 90s, and its corporate and real estate sectors took on massive amounts of debt. A massive real estate and financial bubble formed (does this sound familiar)? Soon, the bubble started to pop:

Thai Financial Crisis

Note: The tipping point came when Thailand’s investors realized that the rate of growth in that country’s property market values had stalled. This made price levels unsustainable. Results were severe. Developer Somprasong Land defaulted and Thailand’s largest finance company, Finance One, went bankrupt in 1997. Next currency traders began attacking the Thai baht’s peg to the U.S. dollar. This was a success. On July 2. 1997. the currency was eventually floated and devalued. Consumers lost their spending power. Loans taken out when the currency was worth more became impossible to payoff.

Soon, other Asian currencies all moved sharply lower. Among them were the Malaysian ringgit Indonesian rupiah, and Singapore dollar. These devaluations led to high inflation and a host of problems that spread as wide as South Korea and Japan.

Thailand’s hand was forced, and the Thai Central Bank decided to devalue its currency relative to the US dollar. This development, which followed months of speculative downward pressures on their currency that had substantially depleted Thailand’s official foreign exchange reserves, marked the beginning of a deep financial crisis across much of East Asia.

In subsequent months, Thailand’s currency, equity, and property markets weakened further as its difficulties evolved into a twin balance-of-payments and banking crisis. Malaysia, the Philippines, and Indonesia also allowed their currencies to weaken substantially in the face of market pressures, with Indonesia gradually falling into a multifaceted financial and political crisis.

Asian Financial Crisis

As the president of Liberia, you see what can happen when a country, especially a small third-world country, doesn’t have enough dollar reserves to defend its own currency. Rippling currency devaluations, inflation, social and political unrest, widening economic inequality- the beginning of a death spiral of a country if you aren’t careful.

So, you tell the IMF that you agree to their terms. They impress upon you that you need to get your bank to buy up some other stable currency to hold as reserves, to defend against this very scenario. As the US dollar is the World Reserve Currency, you’re going to hold it as the majority of your reserve position.

We’ve established the need for a small country to hold another currency on its balance sheet. If ONE small country does this, there is little impact on the US Dollar. However, under the current system, virtually EVERY country has a central bank, and they all use the Dollar as their main reserve currency. This creates MASSIVE buying pressure on Treasuries. Using Liberia as an example, the process works like this:

Dollar Recycling

THIS is what French Finance Minister Valéry Giscard d’Estaing meant when during the 1960’s he had contemptuously called this benefit the US enjoyed le privilège exorbitant, or the “Exorbitant privilege”. He understood that the United States would never face a Balance of Payments (currency) crisis (*AS LONG AS THE USD IS THE WORLD RESERVE CURRENCY*), nor a debt crisis, due to forced buying of Treasuries (from Central Banks) and Dollars (from Petrodollar system).

The US could borrow cheaply, spend lavishly, and not pay for it immediately. Instead, the payment for this privilege would build up in the form of debt and dollars overseas, held by foreigners all around the world. One day, the Piper HAS to be paid- but as long as the music is playing, and the punchbowl is out, everyone gets to party, dance & drink to their hearts’ content, and the US can remain the belle of the ball.

Effectively, the US can print money, and get real goods. This means we can import consumer products for cheap, and the inflation we create gets exported to other countries. (ONE of the reasons why developing countries tend to have higher inflation). Another way to explain it:

Exporting Inflation, importing goods

As it is the WRC, other countries’ Central Banks NEED to have US dollars on their balance sheet. Thus, the US has to run persistent current account deficits in order to send out more dollars to the global system, on net, than it receives back. A major byproduct is constant large and increasing trade deficits for the WRC holder (in a fiat money system).

This is what is known as Triffin’s dilemma: the WRC is HAS to run constant trade deficits. There are no immediate negative impacts, but in the long run this process is unsustainable, as the WRC country becomes unproductive (ever wonder why US manufacturing left) because the system forces the WRC holder to be a net importer.

As world trade grows, the current account deficit/trade deficit grows, and the benefits (more goods to the US) and drawbacks (more dollars build up overseas) increase over time. Eventually, the imbalance becomes so great that something snaps, just like it did for the Pound post WWI, where policymakers chose the route of deflation in 1921, creating a Great depression for the UK long before the US ever experienced it.

US Trade Deficit broken down by Goods/Services

This is why I laughed out loud when I heard Trump rail against our trade deficits in one of the 2016 presidential debates. He clearly did not understand how our system works, and that this issue was beneficial in the short term but detrimental in the long term. Our trade deficits were symptoms of our system working exactly as intended.

In fact, a large part of the reason why he was elected was the de-industrialization of the American heartland, where loss of economic vitality from manufacturing jobs was leading to rampant drug abuse, depression, and societal decay. I knew this process of deindustrialization would only get worse with time, and nothing he did (short of taking us off the WRC status) would change that. (Not political, other politicians say the same shit. They just don’t understand the very system in which we operate).

Fast forward to today- After decades of this process playing out, Foreign Central Banks collectively hold huge amounts of Forex reserves, as you can see below where countries are sized depending on their reserves of foreign currency exchange assets:

Central Banks FX Reserves

The majority of these reserves are held in dollars, mainly in the form of Treasuries, T-bills, and other US government debt. Furthermore, the US Dollar continues to dominate global trade through the SWIFT network (Society for Worldwide Interbank Financial Telecommunication). SWIFT is a payments system used by multinational banks, institutions, and corporations to settle trade worldwide.

USD is the preferred payment method within the system, thus forcing other countries to adopt the dollar in international trade. This is one of the results of the petrodollar system we described earlier. Petrodollars originally were exclusively used to refer to oil contracts priced in USD from Saudi Arabia, but over time the name grew to mean any oil contract, transacted by non-US countries, using the US Dollar as the denomination.

Most FX Reserves in Dollars

When Chile and South Africa trade copper, for example, they have to transact in dollars, because a SWIFT member bank in South Africa will not accept Chilean Pesos as payment, as there is a smaller, less liquid market for it and it doesn’t want to take a trading loss when converting to a more usable currency. The contract itself is priced in USD, so if that merchant bank wants to sell it, they can quickly find a buyer. In fact, SWIFT itself published a report in 2014, and found that the USD accounts for almost 80% of all world trade! (see top left)

Currencies as a % of Trade

This process is called dollarization, whereby the dollar is used as the medium of exchange for a contract, in place of some other currency, even between non-US trading partners (Iran and China for example). Dollarization (capital D) of a country occurs when a government switches from managing their own currency to just using the US dollar for trade settlement and tax revenue- like Ecuador, El Salvador, and Panama have done.

The US Dollar reserves from the petro-dollar system show up on the balance sheets of these overseas financial institutions; they are called Euro-Dollars, and these USD denominated deposits are not under the jurisdiction of the Treasury or Federal Reserve. If you want to read a brief history of the Euro-dollar market, check out this paper from the Federal Reserve bank of St. Louis here. In 2016, the total value of the Eurodollar Market was estimated to be around 13.83 Trillion.

Through this process, the United States was able to become the largest and most dominant military force in the history of man, able to fight simultaneous two-theater wars with overseas supply lines. The Treasury could borrow and spend, unimpeded by the normal constraints of market discipline that were hoisted on other countries. Despite not declaring war since 1941, the US has been in a state of near-continuous warfare.

American Military Budget

At every turn, the US defended this system at all costs, even going so far as to directly invade and occupy the Middle East in the Gulf War in 1991 and the Iraq/Afghanistan War (2001-Present). As a result, there are over 800 US military bases around the world, in locales ranging from Turkey to Japan. American institutions like the Senate, Presidency, and Courts were modeled after their Roman antecedents, to the point that the American symbol, the Eagle, is the spitting image of the Roman Aquila adorned on the Standard of the centurions.

Rome

Most scholars tout the story of Rome as a tale of triumphalism; of valiant centurions battling in the steppes of Asia, of brilliant generals laying traps for enemy armies, of scheming senators fighting battles of political intrigue, and of a sophisticated and well-functioning empire that harnessed engineering to create marvels such as the Colosseum and the Roman Aqueducts. More sober historians, however, point out that the story of Rome is one that also echoes a warning through the annals of history.

A complex society, with mighty political, legal, and financial institutions, supported by a massive military, fell not to a crushing enemy invasion, but to collapse and decay from within. An elite ruling class, detached from the realities of the daily life of the citizens, oversaw an empire with growing income inequality, environmental degradation, political corruption, social deterioration, and economic despair, and did nothing to stop it.

The Roman Treasury, facing insurmountable debts from years of fruitless war, started “clipping coins” an early form of currency debasement that led to the Roman denarii losing 25% of its value every year. This eventually led to uprisings in Roman provinces and the Sacking of Rome- the coup de grace, the final nail in the coffin for what had become the decadent Western Roman empire.

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Smooth Brain Overview:

  • Petrodollars: Oil contracts priced in dollars mean foreign companies need to have dollars to buy oil. This creates artificial demand for dollars as companies sell their local currency to buy USD.
  • Triffin Dilemma: As the US is WRC, other countries’ Central banks need USDs. US thus runs deficits to push more $ out to the world to satisfy demand. This means cheap goods in the short term, but debt/dollar buildup overseas long term. Because of this, no country can remain WRC holder forever.
  • Eurodollars: Due to the petrodollar system, USDs build up in overseas bank accounts. These dollars are used by SWIFT for most international payments and are called Eurodollars (due to the fact that most US dollars after WW2 ended up in Europe). The size of this market is roughly $14T.
  • Foreign Exchange Reserves: Due to the Triffin Dilemma & structure of WRC system, dollars build up in reserve accounts of foreign central banks. Wanting to earn interest on this cash, CBs invest in treasuries, effectively lending to the US Govt at low interest rate. $4T of these treasuries are held by these CBs, and $2T of these treasuries are held by private institutions.

Conclusion:

If the US loses World Reserve Currency status, two things happen. 1) Foreign central banks start massively dumping their huge Treasury/Dollar debt positions and 2) SWIFT member banks who hold USDs for cross-border payments (EuroDollars) decide to dump them as they see the writing on the wall and see the value of their assets decreasing by the day. This is one of the many Swords of Damocles hanging over the global financial system.

The unraveling of these massive currency positions would truly be catastrophic. Interest rates could effectively jump to +30% or more overnight, creating an immediate solvency crisis for the US Government and most banks, corporations, and state governments who rely on low interest rate borrowing. DXY would be whipsawed violently before being forced downward by massive selling pressure from the Eurodollar market. Other currencies would be pulled higher and then lower in volatile moves matching the worst days of the early Nixon crisis. But, this is only part of the story. We will come back to this later.

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Epilogue:

We’ve gone over a brief history of the Bretton Woods system, and it’s transformation to a complete fiat money system starting in 1971. The US as a World Reserve Currency holder is allowed to borrow almost indefinitely without immediate consequence, but this creates massive amounts of US dollar debts overseas. The last time global creditors started to lose faith in the US dollar, we saw massive inflation, unemployment, and stagnation in the US, in a period of rapid demographic and economic growth in the rest of the world. If creditors become worried again, and signs are showing up that they are (more on this in PT4) the results could be catastrophic.

PART 2

The Ouroboros — The Dollar Endgame

Some Terms you need to know:

Derivatives: A derivative is a financial security with a value that is reliant upon or derived from, an underlying asset or group of assets — a benchmark. The derivative itself is a contract between two or more parties, and the derivative derives its price from fluctuations in the underlying asset. The most common underlying assets for derivatives are stocks, bonds, commodities, currencies, interest rates, and market indexes.

Normalized Curve Distribution (Bell Curve): The normal distribution is a continuous probability distribution that is symmetrical on both sides of the mean, so the right side of the center is a mirror image of the left side. The area under the normal distribution curve represents probability and the total area under the curve sums to one. (We’ll go over this more in-depth later).

Value-At-Risk (VaR Distribution): Value at risk (VaR) is a statistic that measures and quantifies the level of financial risk within a firm, portfolio or position over a specific time frame. This metric is most commonly used by investment and commercial banks to determine the extent and occurrence ratio of potential losses in their institutional portfolios. Risk managers use VaR to measure and control the level of risk exposure.

Rehypothecation: Rehypothecation is a practice whereby banks and brokers use, for their own purposes, assets that have been posted as collateral by their clients. Clients who permit rehypothecation of their collateral may be compensated either through a lower cost of borrowing or a rebate on fees.

Exchange-Traded (Listed) Derivative: An exchange-traded derivative is merely a derivative contract that derives its value from an underlying asset that is listed on a trading exchange and guaranteed against default through a clearinghouse. Due to their presence on a trading exchange, ETDs differ from over-the-counter derivatives in terms of their standardized nature, higher liquidity, and ability to be traded on the secondary market.

Over the Counter Derivative: An over the counter (OTC) derivative is a financial contract that does not trade on an asset exchange, and which can be tailored to each party’s needs. Over the counter derivatives are instead private contracts that are negotiated between counterparties without going through an exchange or other type of formal intermediaries, although a broker may help arrange the trade.

Prologue:

The Ouroboros, a Greek word meaning “tail devourer”, is the ancient symbol of a snake consuming its own body in perfect symmetry. The imagery of the Ouroboros evokes the concept of the infinite nature of self-destructive feedback loops. The sign appears across cultures and is an important icon in the esoteric tradition of Alchemy. Egyptian mystics first derived the symbol from a real phenomenon in nature. In extreme heat, a snake, unable to self-regulate its body temperature, will experience an out-of-control spike in its metabolism.

In a state of mania, the snake is unable to differentiate its own tail from its prey and will attack itself, self-cannibalizing until it perishes. In nature and markets, when randomness self-organizes itself into too perfect symmetry, the order becomes the source of chaos, and chaos feeds on itself.”-

(Artemis Capital Research Paper- extra credit reading, but warning, this is ADVANCED finance- you’ll pop a lot of wrinkles reading it)

Random Walks and Portfolio Insurance

In financial markets, traders have long looked for mathematical relationships between and within assets, to aid in speculation and price prediction. As data aggregation improved, and information became more widely distributed in the 1930s and 1940s, Financial analysts quickly realized that the stock market as a whole, as well as individual securities, followed Bell Curve Distributions, at least in most time periods.

The performance of individual securities on a single day was essentially random, but their overall performance in a time period could be graphed, as seen below:

Bell Curve Distribution fitted to Market Returns

This flowed logically from the concept of random events that Brownian motion described. In the mid- 1800s, scientist Robert Brown saw that particles in a fluid sub-domain bounced around randomly, with their individual movements being essentially unpredictable- these movements were completely random. Drawing on Brownian motion, mathematicians had created Probability Theory, which could estimate the given probability (not certainty) of a set of outcomes.

As an analogy, predicting the result of an individual coin toss accurately every time is essentially impossible, but if you do it 100 times, Probability theory will tell you that you have a very high probability of 50 heads and 50 tails, or something close to it (45/55 or 53/47 for example).

The likelihood of 95 heads and 5 tails, an extreme outlier, would be very close to 0. This is because there is a 50% probability of either heads or tails- and thus the distribution of 100 coin flips should roughly match this probability. This theory of randomness of prices as it applied to finance came to be known as the Random Walk Theory- and predicted that prices were basically completely unpredictable.

Understanding this concept, traders in the 1960s observed that the probability was great that returns on a single equity security would hover between some set performance range, like -10% and +10%. Rarely did the return hit the extreme ends of the curve.

It didn’t matter what the time period was, 1 day, 1 month, or 1 year, the traders always had trouble reliably predicting a single future movement (like predicting heads/tails on a single coin toss), but could reliably say what the probability of variance over time (outcome of 100 coin tosses) would be, and map this mathematical distribution on a bell curve.

These Bell Curve distributions, after being modified for applications in financial markets, came to be known as Value At Risk (VaR) models. Over the course of the 1960s and 1970s, these models came to be widely used in the asset management industry.

Essentially what these VaR models could do was provide a statistical technique used to measure the amount of potential loss that could happen in an investment portfolio over a specified period of time. Value at Risk gives the probability of losing more than a given amount in a given portfolio.

Value-at-Risk Model

You can see from the above that these models have “skinny tails”, that is to say, they predict the likelihood of extreme events (standard deviation of 3 or more) happening as very low- especially on the downside (see above). Outlier events were thus coined “tail risk”, occurrences that only show up on the far tails of the distribution. Tail risk events were shown to be SO unlikely that the fund managers basically didn’t hedge for them AT ALL.

These models were built using the recorded historical prices of thousands of commodities, equities, and bonds. For earlier markets, they would even plug in estimates created by econometricians (i.e. Corn prices in 1430) to arrive at a large enough data set.

With this data, asset managers could feel safe utilizing leverage and complex derivatives in risky investments, as these models told them that the likelihood of severe losses (-30% for example) in a single day was near-zero. (Fundamental rule of math is you CANNOTfor certain predict future outcomes based on past experiences- but they did it anyways…)

At the same time, Eugene Fama, an American economist freshly minted with a PhD from the University of Chicago, developed his Efficient Markets Hypothesis in early 1970. Drawing on the random walk theory, Fama posited that since stock movements were random, it was impossible to “beat the market”.

Current market prices incorporated all available and future information, and thus buying undervalued stocks, or selling at inflated prices, was not feasible. Making consistent profits was impossible- if you made money, you just got “lucky” as the market randomly moved in your favor after you made the trade. The price, therefore, was always “right”.

Efficient Market Hypothesis

This further emboldened investors and whetted their risk appetite. Armed with these two theories, they started making statistical algorithms that modeled the stock market, and loaded themselves up with more risk. Starting in the early 1980s, portfolio insurance started to gain traction within the industry. This “insurance” basically was an automated system that short-sold S&P 500 Index futures in case of a market decline.

This concept was invented by Hayne Leland and Mark Rubinstein, who started a business named Leland O’Brien Rubinstein Associates (LOR) in 1980, and was developed into a computer program commonly referred to by the same acronym. They were successful in marketing this product, and by the mid-1980s, hundreds of millions of dollars of Assets Under Management (AUM) from institutions ranging from investment banks to large mutual funds were protected by this new-fangled product.

LOR was a program that dynamically hedged, i.e. would observe market conditions, and understanding its own portfolio risk, would actively adjust in real time. Today, dynamic hedging is used by derivatives dealers to hedge gamma or vega exposures. Because it involves adjusting a hedge as the underlier moves — often several times a day — it is “dynamic.”

The founders of LOR touted it as a program that would actively work to protect a portfolio, a “fire and forget” approach that would allow portfolio managers and traders to focus on alpha-generation rather than worrying about potential losses.

Smoothbrain summary:

  • No one can accurately predict the future (ie the outcome of a single coin toss). But, you can predict the probable outcomes of a series of coin-tosses.
  • Using this theory of the probability of outcomes, you can build a bell curve of probabilities of returns. Adapting this to financial markets, it comes to be called the Value-At-Risk model.
  • This Value At Risk model tells you that the likelihood of a severe adverse event happening (large losses in a single day) is very low. Thus you feel safe leveraging your portfolio and buying derivatives.
  • The Efficient Markets Hypothesis tells you that it is near impossible to consistently beat the market. Prices are always “right” and already incorporate all known and knowable information, so fundamental (and technical) analysis is completely useless. Thus the best way to juice returns is to load up on leverage and derivatives.
  • Two experts in the fields of finance and economics create a new product called LOR, which was ‘portfolio insurance’ that promised to limit downside losses in case of a market collapse. Hundreds of institutions, banks, and hedge funds buy and implement LOR’s dynamic hedging into their portfolio. This program short-sold S&P 500 futures in the event of a market decline.

Black Monday- October 19, 1987

Stock markets raced upward during the first half of 1987. By late August, the DJIA (Dow Jones) had gained 44 percent in a matter of seven months, stoking concerns of an asset bubble. In mid-October, a storm cloud of news reports undermined investor confidence and led to additional volatility in markets.

The federal government disclosed a larger-than-expected trade deficit and the dollar fell in value. The markets began to unravel, foreshadowing the record losses that would develop a week later.

Beginning on October 14, a number of markets began incurring large daily losses. On October 16, the rolling sell-offs coincided with an event known as “triple witching,” which describes the circumstances when monthly expirations of options and futures contracts occurred on the same day.

By the end of the trading day on October 16, which was a Friday, the DJIA had lost 4.6 percent. The weekend trading break offered only a brief reprieve; Treasury Secretary James Baker on Saturday, October 17, publicly threatened to de-value the US dollar in order to narrow the nation’s widening trade deficit. Then the unthinkable happened.

DJIA (Tradingview) — Historical Realized Volatility on the bottom scale

Even before US markets opened for trading on Monday morning, stock markets in and around Asia began plunging. Additional investors moved to liquidate positions, and the number of sell orders vastly outnumbered willing buyers near previous prices, creating a cascade in stock markets.

In the most severe case, New Zealand’s stock market fell 60 percent, and would take years to recover. Traders reported racing each other to the pits to sell. Author Scott Patterson describes the scene:

The Quants, pg 51

Traders on the floor of the NYSE reported seeing ticker numbers spinning so fast that they were unreadable. Liquidity vanished completely from the market. Sell orders flooded in so fast the infrastructure to record them started malfunctioning.

At one point, specialists (individual market makers, and at this time were people on the floor representing a firm) simply stopped picking up the phone, which was ringing with dozens of institutions begging them to sell.

Dozens of stocks were frozen in time. Those that weren’t were hit with massive volume. At one point, Proctor and Gamble was trading for $0.03. It had ended trading the previous Friday at $6.09. Market makers were trading off the stock prices that were recorded an hour ago, since the infrastructure was so backed up. (Check out this episode of RealVision Podcast to learn more. In fact, just go subscribe to their show and start listening from the beginning, they have one of the best finance podcasts out there).

In the United States, this collapse quickly came to be known as “Black Monday”, with the DJIA finishing down 508 points, or 22.6 percent. “There is so much psychological togetherness that seems to have worked both on the up side and on the down side,” Andrew Grove, Chief Executive of technology company Intel Corp., said in an interview. “It’s a little like a theater where someone yells ‘Fire!’ (and everybody runs for the exit)”.

“It felt really scary,” said Thomas Thrall, a senior professional at the Federal Reserve Bank of Chicago, who was then a trader at the Chicago Mercantile Exchange. “People started to understand the interconnectedness of markets around the globe.”

For the first time, investors could watch on live television as a financial crisis spread market to market — in much the same way viruses move through human populations and computer networks. (Source).

Black Monday represented a catastrophic rebuttal to the mathematicians and economists who created the Random Walk Theory and Value- At- Risk models. These probability theorists had stated that events like this were improbable- so improbable in fact that their models predicted Black Monday was IMPOSSIBLE. Thus, no one in the market had hedged or expected an event as extreme as this. In fact, some theoreticians started to doubt the validity of the previously iron-clad Efficient Market Hypothesis itself. Patterson continues:

The Quants, pg 53

Black Monday also represented a fascinating case study in the devastating effects of derivatives on financial markets. The Index Arbitrageurs, buying the S&P 500 futures being sold by portfolio insurance, had raced to short sell the underlying stock to stay net neutral. This was because by owning the S&P 500 futures, they effectively owned a small piece of every stock in the index. To hedge, they had to quickly short the underlying, so that any large loss in the index futures they owned would be offset by a gain on a short position in the individual stocks.

However, the S&P 500 index itself was calculated based on the prices of the underlying securities. Thus, after Portfolio insurance sold the arbs’ futures, the Index arbs short sold billions of dollars worth of stock, the S&P future market tanked, and LOR, seeing the massive volatility and downward pressure on the market, sold more and more futures, which caused the Arbs to short more and more stock. This was the unwelcome discovery of a vicious positive feedback loop, a “shadow risk” that existed beneath the surface of the market, unbeknownst to the investors who traded in it. The Ouroboros had been awakened. These feedback loops, once initiated, continued until the underlying factors have been diminished or until the agents in the system are self-destroyed.

Derivatives and the Alchemy of Risk

Derivatives are financial contracts that derive their value from an underlying security and have existed for as long as markets have. A futures contract, for example, is a legal agreement to buy or sell a particular commodity asset, or security at a predetermined price at a specified time in the future.

The buyer of a futures contract is taking on the obligation to buy and receive the underlying asset when the futures contract expires, and the seller of the futures contract is taking on the obligation to deliver the underlying asset at the expiration date. These contracts have been around for millennia, with the earliest recorded contract dated to 1750 BC in Mesopotamia, or modern-day Iraq.

Say you’re in a casino and you want to make money off a poker game, but you are barred from playing the actual game. So, you grab another patron (Dave) and tell him you’d like to make a bet on the outcome of the game. You really think your friend Allie will win the game, so you’re willing to pony up $100 to bet on her winning. (In this example, the bet you make is the “derivative”. The underlying security’s returns are the results of the poker game.)

Seeing your derivative bet, two other people get interested. They don’t want to bet on the game, rather they want to gamble on the outcome of your bet. They create their own bet, weighing probabilities and putting in funds accordingly. This is a second-order derivative. In the modern financial system, since derivatives are basically unregulated due to the Commodities Futures Modernization Act, (especially OTC derivatives or second-order or higher) this process can continue ad infinitum.

Derivative Bets

In doing so, the “derivative” gamblers are essentially creating leverage on the poker game. What financial institutions do with derivatives is create these bets (Derivative² for example) and then sell these bets to others. This is an IMMENSELY profitable business for them.

When creating a portfolio, most investors worry about their loss exposure. Buying any single equity is risky, and it is reasonable to want to reduce downside risk. This is part of the reason why derivatives were created. Through hedging, traders were able to change their gross exposure into a net exposure. Net exposure underlines the difference (net amount) between a hedge fund’s long positions and its short stock or derivative positions. Once calculated, the net exposure of a fund is usually presented in a percentage, displaying the fund’s risk with regard to market fluctuations.

Let’s break it down. Say you are bullish on IBM. You go out and buy $50M of long dated call options (commonly called LEAPS) on IBM. Since you’re afraid of losing money in case IBM misses its earnings call, loses revenue, or experiences some other negative event while your position is open, you go and buy $40M of put options with the same expiry date. Thus, your new Net exposure position is only $10M long.

Net Exposure Hedging

Using this mechanism, traders were able to hedge positions and reduce their theoretical risk. When you buy calls and puts, this net exposure is reduced, and at the same time, your assets increase. In the example above, your gross exposure (the gross value of the derivatives you own) will increase as you own both long calls and long puts. ((Don’t get this confused with being long/short or bullish/bearish a stock!! A long position for derivatives simply means YOU OWN the contract, a short position means YOU OWE the contract. “Long/Short” is a general term in finance that can mean different things depending on the context!! Read this if you’re confused))

Since both these calls and puts have a value that you paid for and represent the right to exercise at strike, they are both recorded as assets on your Balance Sheet. In the example above, you OWN $50M of calls and $40M of puts- your overall derivative gross exposure is $90M. Your net exposure is only $10M. Thus you have $90M of assets (subject to market changes of course) and a “net risk” of $10M. This is why Shitadel has buttloads of options on either side of every stock, they’re hedging their net exposure, even when they’re bullish on the underlying.

There are three interrelated ways this goes seriously wrong. One is counterparty risk. A counterparty is someone who takes the opposite side of your trade- so if you are buying, they are the seller, and vice-versa. ((I wrote this DD on counterparties and clearinghouses a while ago)) In derivatives, if the counterparty to your trade fails, i.e. goes bankrupt, the contract will most likely not be honored.

This means if you are a hedge fund, and you wrote OTC options ((NOT Exchange traded-please refer to the beginning for the difference between OTC and exchange traded options, exchanged traded options are guaranteed and cleared by OCC (Options section of DTC), OTC options are NOT guaranteed, and can only be written between institutions)) your $90M of calls and puts, if they were written with a single counterparty (like Bear Stearns) will now be worth NOTHING.

This $90M “gross exposure” loss would represent an 800% HIGHER LOSS than the “theoretical” maximum loss of $10M which is your “Net Exposure”. If an options clearinghouse which is the counterparty to all listed options fails, MILLIONS of contracts would be worthless. The TRUE RISK is counterparty risk- this is what the models don’t understand.

Another way this goes wrong is if the underlying fails- the results are equally catastrophic. Going back to the poker game analogy, imagine if the people playing the actual poker game left the table. Now Derivative Bet #1 is worthless, since there’s nothing to bet on. Same goes with Derivative bet #2, and #3, and so on. If the Poker game had $25 in the pot, and each Derivative bet had $100 in each bet, this means that by the poker game ending, $325 worth of value was destroyed, from the elimination of just ONE REAL game worth $25. THIS is the explosive nature of derivatives.

Synthetic CDO Visualized

Let’s use the 2008 financial crisis as an example of an underlying failure. (W Homeowner goes out and gets a loan (original poker game). The bank then sells that loan to an investment bank that makes a CDO out of it (a bet on the game) which trades on the value of the underlying. Then, another bank comes along and makes a synthetic CDO (a bet on the bet), and then takes out a Credit Default Swap on it (bet on a bet on a bet). This creates insane leverage to the underlying, and horribly dangerous results if the underlying collapses. Our beloved Dr. Trimbath puts it like this: (Naked, Short and Greedy (Ch 19))

Naked, Short and Greedy pg 221

A third way this system can blow up is due to cross-collateralization, where one asset is pledged to multiple entities, creating more claims than assets that exist. This process is actually very common in the futures markets- bullion banks, for example, which hold gold and silver, will write between 2–10 futures contracts for every one oz of gold in the vaults.

One Asset pledged to multiple parties

In the example above, the bullion bank (with the gold) writes 6 futures contracts (assume 1 oz per contract) and sells them to other financial institutions, but only has a single ounce of gold in the vault. They can do this since the vast majority of the futures (~85–90%) never get called in for settlement, and are instead rolled forward (this basically means when the old contract is about to expire, the holder sells it for cash and then uses this money to buy a new futures contract with a different expiration date).

Thus, the bank/institution writing all these futures never has to actually deliver the underlying- the gold in this case. If all the futures contracts they write are called in at once, then the 1 oz of gold is given to the buyer, and the bank who wrote the contract is on the hook to deliver all 5 oz to the firms that are owed and is forced to go into the market to purchase it- this is called a “Contract Delivery Squeeze” as outlined in this paper. If the bullion bank fails, all the futures written by it are now null and void, and the firms that weren’t able to take delivery get nothing.

(Side note: Notional Value Explained: Notional value is a term often used to value the underlying asset in a derivatives trade. It can be the total value of a position, how much value a position controls, or an agreed-upon amount in a contract.

— — — — — — — — — — — — — — — — — — — — — — — — — — — — — — —

The Market Value is the value of the derivative at its current trading price.

The Notional Value is the value of the derivative if it was at its strike price.

E.g. A CALL Option represents 100 shares of ABC stock with a strike of $50. Perhaps it is trading in the market at $1 per contract right now.

  • Market Value= 100 shares * $1 per contract = $100
  • Notional Value= 100 shares* $50 strike price= $5,000

— — — — — — — — — — — — — — — — — — — — — — — — — — — — — — —

Nitroglycerin

Imagine you go to the office one day, and see your boss (Anna) sitting there with a bottle of nitroglycerin. You are immediately shocked, and ask Anna what she’s doing. “Are you INSANE?” you say. “That is extremely dangerous!”. She smiles at you and says “Nitroglycerin is stable if not exposed to pressure or heat. It’s safe on my desk, as long as I don’t knock it off, it won’t explode”. Incredulous, you walk away.

The next day she brings in another bottle. And another the day after that. Over a year, she brings in hundreds of bottles of nitroglycerin. One day, a poor intern trips on her shoes and knocks one down. The first bottle explodes- Boom. In a few milliseconds, the next one does, and the next, in a vicious chain reaction- BOOM! BOOOM! BOOOOOM!. The entire building is destroyed. THIS is the danger of derivatives.

Systemic Risk

The recent Archegos Capital debacle was a classic example of the destructive power of derivatives. Using contracts like Total Return Swaps, Bill Hwang was able to leverage his fund more than 8x, making bets on the performance of a variety of Chinese and American equities. When the equities lost value, his fund was obliterated- a mere 12.5% drop in the underlying resulted in a complete loss of capital.

But, his fund wasn’t the only firm affected- Credit Suisse was his counterparty, and thus lost more than $5.5 Billion, and counting. If derivatives are an explosive bottle, counterparty risk is a fuse- one that always runs to another bottle of Nitroglycerin.

The modern financial system is effectively a complex network of institutions, tied to each other through these complex derivative contracts. GSIBs (Globally Systemic Important Banks) are the largest entities in the system, tied directly to thousands of institutions, and indirectly to hundreds of thousands. Here’s a fascinating map from an IMF White Paper on the GSIBs’ interconnectedness:

IMF White Paper, 2016. (See legend for details)

The entire derivatives market is HUGE. The BIS estimated the total notional value of the OTC derivatives market to be $640 Trillion in 2019! And that doesn’t even include exchange-listed derivatives like most common option contracts. More sober estimates put it somewhere north of $1 Quadrillion. Visual Capitalist has a great graph that demonstrates the monstrosity of this number. Numbers of this size are hard to wrap your head around- this is equivalent to a million billion, or a thousand trillion- for reference, the US economy is around $22 Trillion and the world economy is estimated to be $88 Trillion- thus the entire world economy could fit into the notional derivatives market 11x over and STILL not reach it. Every single bank is exposed, either directly or indirectly, to this market. For example, Deutsche Bank ALONE has over $47 Trillion in Notional gross exposure- TWICE the size of the entire US Economy!

Through the magic of financial engineering, Deutsche is able to create a net exposure of only $22 Billion, equivalent to 0.046% of the notional. Thus, although on paper its risk is extremely small, the actual risk to the firm is enough to wipe it out basically overnight. This is what happened to institutions like AIG in the 2008 crisis — they insured more products than they could ever cover, and when the firms they insured came calling they were quickly forced into bankruptcy, requiring a $182 Billion bailout from the Federal Reserve.

If the hedge funds with derivatives exposure (like Archegos) are the equivalent of an office rigged with nitroglycerin, the banks are stadiums full of 50 gallons drums of this shit- and the DTCC/ICC/OCC are the equivalent of a nuke. Counterparty risk, in the form of fuses, runs between all of them. What happens when enough factors on the system start to apply too much pressure? BOOM.

Los Alamos Testing Grounds, Nuclear Bomb

Why hasn’t anything happened?

This is the question most people ask themselves when they first learn about this. The reason is actually very simple. As long as the money keeps flowing into the Casino, the gamblers feel little risk, so no one pulls out. The Fed continues to print money, equity/bond prices continue to rise, and since there’s “no risk” of the underlying falling in value, everyone keeps their money in the pot, and the poker game continues.

The profits made from derivatives trading are enormous, and any bank that stopped doing this would quickly lose investors because they would instantly take their capital out and take it to another bank that actually is profitable. It’s all a confidence game- as long as everyone is confident, prices keep rising, and the cash keeps pumping in, the party will continue.

Warren Buffet famously turned down calls to buy Lehman Brothers during the darkest days of the Financial Crisis- he understood a key concept, that derivatives (especially when they make up the majority of your fund (hey Kenny :) ) are equivalent to Financial Weapons of Mass Destruction, able to destroy entire firms, and indeed entire systems, in one fell swoop.

Quote from Berkshire Hathaway Shareholder Letter, 2002

In the tumultuous month of October 2008, this system was beginning to unravel. The money draining out of the financial system due to bank runs and frozen credit lending started to light fires in multiple financial institutions. The bombs that were Bear Sterns, AIG and Lehman had already blown up, and the fire was spreading through counterparty risk throughout the system. In fact, we were getting dangerously close to hitting the switch on the nuclear warhead- As Timothy Geitner (Pres of New York Fed) put it, “We were a few days away from the ATMs not working” (start the video at 46:07). (Seriously, go watch this documentary. It's fucking AMAZING).

And the worst part of all of this? Even to this day, Regulators, and indeed even financial industry insiders, are completely blind to the risk. OTC Derivatives are essentially unregulated- NO ONE knows the true size of this market. Worse yet, the traders inside the bank are using optimistic versions of the Efficient Market Hypothesis and VaR models to estimate their risk, which comes out to essentially 0 due to the risk models and net exposure hedging. Thus, they pile on more risk every day, ensuring that this problem continues to grow — until the entire system explodes.

Smoothbrain Overview:

  • Analysts noticed statistical patterns in stocks. Small moves (1%) were much more common than large moves (20%). They created models called Value-at Risk, which predicted extreme losses were not just unlikely, they were virtually IMPOSSIBLE. Thus Fund managers feel more confident and gamble on riskier and riskier investments. The Financial Services Industry STILL uses these VaR models today.
  • Eugene Fama creates the Efficient Market Hypothesis. Since prices are “random” they are unpredictable- and also always “right”. Thus there is no way to beat the market, the best thing one can do is leverage up and ride the market up.
  • Certain market dynamics like index arbitrage, counterparty risk, and shorting (both legit and naked) create positive feedback loops, processes that feed on themselves EXPONENTIALLY (‘The Ouroboros’) to the upside or downside. These processes can lead to extreme dislocations in price movement, like a short squeeze (GME) or a rapid equity market collapse (Black Monday).
  • Derivatives are created with the goal of reducing risk, and they do, to a certain extent, but they also amplify risk- and create potential losses multiples greater than what the fund managers expected.
  • Through hedging, traders believe they reduce net exposure and thus overall firm risk. After hedging, they feel safe buying exotic financial products and leveraging the firm even more. They believe that their ONLY RISK is Net Exposure- but the TRUE RISK is Gross exposure- They essentially are BLIND to the real exposure of the firm.
  • The entire financial system is filled to the brim with derivatives- everyone is exposed. The total notional market is estimated to be somewhere around $1 Quadrillion, with some estimates putting it even higher. This represents what Buffet called “A Time Bomb” in the market- as long as money flows in, the party continues. Once it stops, the Weapons of Financial Destruction are unleashed.

Conclusion:

The modern international financial system, unhinged from the fetters of regulation and oversight, has created a derivatives monster whose tendrils reach across the globe. Fed by the incessant money printer and holding the retirement funds of generations, this machine continues to bet, in ever-increasing amounts, in the greatest casino ever created. This monster, as long as it is nourished by cheap credit and ever increasing flows of cash from the Federal Reserve, will continue to grow.

This is part of the reason why I believe the Fed is in the endgame- they KNOW that they cannot turn off the liquidity hose, as they would risk destroying the system in its entirety. They have to convince themselves and the market with constant assurances that inflation will remain low, risk is non-existent, and their balance sheet can continue to grow without consequence. Secretly, just like Citadel and Melvin, they are starting to realize they are in a burning building with no way out.