Deflating the derivatives balloon

Dec 10, 2011·Alasdair Macleod

Derivatives have a bad name for many commentators, with some describing them variously as dangerous or even weapons of mass destruction.

The sheer size of over-the-counter derivative markets is staggering. According to the Bank for International Settlements, OTC derivatives stood at $707 trillion at the end of June, nearly fourteen times global GDP and forty seven times that of the United States. This is not as alarming as it seems, since over 87% of this is interest-rate swaps and foreign exchange contracts, business that has a solid commercial foundation. However, with forces like these at work it is easy to understand why people think they would be de-risked if they were regulated.

Such a simplistic view ignores the linkages between a firm’s activities in unrelated markets. This seems to have led to the downfall of MF Global, the eighth-largest bankruptcy in US history. It appears that they were scuppered by perfectly legal off-balance sheet repos-to-maturity in European government debt. It also appears that segregated customer funds were used for this purpose, and not co-mingled with the firm’s funds as first supposed. While final redemption of the sovereign debt was guaranteed by both the individual sovereigns and the European Financial Stability Fund and matched to its funding, MF Global was tripped up by margin calls it was unable to meet. The use of client funds in this manner may turn out to have been perfectly legal and so they are completely lost.

As the story unfolds the result is bound to lead to increased questions about Comex operations, where MF Global was a clearing member; and when confidence is lost turnover is almost certain to decline as users of the markets make hedging and trading arrangements elsewhere. This is already happening. Barnhardt Capital, a small agency broker, was closed by its owner who stated, “I could no longer tell my clients that their monies and positions were safe in the futures and options markets – because they are not”. Last Monday Commodity Online ran a story about how “silver positions are being liquidated by Comex traders after the MF Global fiasco uncovered the fragility of paper assets.” This is very bad news for small traders, but it is also bad news for the large traders who require market liquidity to maintain their short positions.

You simply cannot run a position many times larger than normal dealing size when turnover is contracting, and thanks to a disaster beyond Comex’s control, liquidity is drying up. For the large commercial traders who are short of gold and silver futures this could turn out to be a very serious problem.

The good news is that we are finally witnessing the transfer of pricing-power from futures to physical markets, which at least is a vote for honesty and a step in the right direction.

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