Derivatives and Mass Financial Destruction

By: Alasdair_Macleod

Globally systemically important banks (G-SIBs in the language of the Financial Stability Board) are to be bailed-in if they fail, moving the cost from governments to the depositors, bondholders and shareholders. There are exceptions to this rule, principally, small depositors who are protected by government schemes, and also derivatives, so the bail-in is partial and bail-out in these respects still applies.

With oil prices having halved in the last six months, together with the attendant currency destabilisation, there have been significant transfers of value through derivative positions, so large that financial instability may result. Derivatives are important, because their gross nominal value amounted to $691 trillion at the end of last June, about nine times the global GDP. Furthermore, the vast bulk of them have G-SIBs as counterparties. The concentration of derivative business in the G-SIBs is readily apparent in the US, where the top 25 holding companies (banks and their affiliated businesses) held a notional $305.2 trillion of derivatives, of which just five banks held 95% between them.

In the event of just one of these G-SIBs failing, the dominoes of counterparty risk would probably all topple, wiping out the financial system because of this ownership concentration. To prevent this happening two important amendments have been introduced. Firstly ISDA, the body that standardises over-the-counter (OTC) derivative contracts, recently inserted an amendment so that if a counterparty to an OTC derivative contract fails, a time delay of 48 hours is introduced to enable the regulators to intervene with a solution. And secondly, derivatives, along with insured deposits, are to be classified as “excluded liabilities” by the regulators in the event of a bail-in.

This means a government that is responsible for a G-SIB’s banking license has no alternative but to take on the liability through its central bank. If it is only one G-SIB in trouble, for example due to the activities of a rogue trader, one could see the G-SIB being returned to the market in due course, recapitalised but with contractual relationships in the OTC markets intact.

If, on the other hand, there is a wider systemic problem, such as instability in a major commodity market like energy, and if this instability is transmitted to other sectors via currency, credit and stock markets, a number of G-SIBs could be threatened with insolvency, both through their lending business and also through derivative exposure. In this case you can forget bail-ins: there would have to be a coordinated approach between central banks in multiple jurisdictions to contain systemic problems. But either way, governments will have to stand as counterparty of last resort.

The US Government has suddenly become aware of this risk. In the recent omnibus finance bill a clause was hurriedly inserted transferring derivative liabilities to the Government in the event of a bank failure. What is alarming is not that this reality has been accepted by the politicians, but the hurry with which it was enacted.

Instead of a normal consultative procedure allowing the legislators to draft the appropriate clause, the wording was lifted at short notice from a submission by Citibank, which has some $61 trillion-worth of derivatives on its own books, with virtually no alterations. Either the insertion was correcting an oversight at the very last minute or, alternatively, that it has suddenly become an urgent matter for the too-big-to-fail banks. The coincidence of current market volatility and this hurried legislation cannot be lightly dismissed and suggests it is the latter.

Alasdair Macleod

Head of research, GoldMoney

Alasdair.Macleod@GoldMoney.com

Alasdair Macleod runs FinanceAndEconomics.org, a website dedicated to sound money and demystifying finance and economics. Alasdair has a background as a stockbroker, banker and economist. He is also a contributor to GoldMoney - The best way to buy gold online.

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