The mechanics behind a credit crisis

Jan 18, 2024·Alasdair Macleod

Imbalances in the global fiat credit system are enormous, with foreign ownership of dollars overhanging both foreign exchanges and securities markets. Meanwhile, Keynesian and monetarist hopes that lower interest rates can be implemented to keep things just bubbling along is blinding investors to the real risks.

It is wrongly believed by nearly everyone that lower interest rates are on the way and will stay down. Other than perhaps a minor decline being a self-fulfilling prophecy, in practice the reluctance of banks to lend to businesses will keep rates high. And the redirection of bank credit from productive use to the US Government financing its huge budget deficits by issuing treasury bills is highly inflationary.

This is bound to lead to significantly higher interest rates in time. And higher interest rates will threaten to collapse the entire credit system. 

Irving Fisher’s collateral doom-loop, whereby falling collateral values lead to further collateral liquidation could also come into play. Thinly capitalised regulated exchanges will be a weak point, requiring the entire DTC ledger to be corralled into keeping them functioning. Nothing will be safe.

And those who think that they can protect themselves by buying gold ETFs will probably find that the underlying bullion is diverted “in the interests of the state”, leaving them with vacuous paper promises as their only comfort.

No wonder everyone thinks interest rates must come down. If they don’t, the outcome is too horrible to contemplate.

The dollar’s value dynamics

In today’s complex markets, it is difficult for the layman to understand their workings. It has always been about central and commercial bank credit, which must never be confused with money, and which from the dawn of history has been physical metal. Today, we can say it is almost exclusively gold. But that is the medium of exchange of last resort, hoarded by individuals, and in recent decades increasingly by central banks and Asian interests. 

The layman’s understanding of the difference between credit and money is further undermined by state propaganda which we can trace back to the suspension of the gold standard in America in 1933, which de facto had lasted since the 1850s, and de jure since 1900. This was followed by the naked attempt to expel gold from the monetary system entirely by ending the Bretton Woods Agreement in 1971. Subsequent events have intensified monetary disinformation, leading to a global fiat money system based on the US dollar but detached in value from gold entirely.

In order to give us all the illusion of price stability, the Breton Woods Agreement had been designed to promote the dollar as a gold substitute for all other currencies. Since its suspension, to maintain the dollar’s credibility the US Government increasingly resorted to market manipulation. First, they tried selling gold into the market in the early seventies, which was readily bought and failed to stop the gold price from continuing to rise. The next wheeze was to create artificial demand for dollars in an attempt to support its purchasing power, measured against commodities and other currencies. This led to the expansion of derivative markets, which diverted speculative demand for commodities thereby suppressing their prices below where they would otherwise be. The expansion of the London bullion market which created paper gold, and demand for the dollar not just to settle cross-border trade and commodity pricing but to replace gold in central banks’ reserves was all part of the deception. 

Over the fifty-two years since Bretton Woods was suspended, huge dollar imbalances have accumulated. A table of recent estimated bank and shadow bank dollar balances, onshore and offshore, is shown below.

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The offshore element is considerably larger than that registered in the US Treasury’s TIC numbers for onshore securities, which in itself tells us that foreign interest in onshore dollar investments and bank balances only exceeds US GDP by a fair margin. The offshore element is based on the Bank for International Settlements analysis of dollar deposits and short-term obligations outside the US financial system which we can equate with the eurodollar market. In the main, they are currency forwards and swaps where one leg is in US dollars. By way of contrast, US Residents’ claims in foreign currencies are remarkably small. But this is because long-term securities are held overwhelmingly in ADR form: ADRs are denominated in dollars and sales of them by US investors do not give rise to foreign currency exposure.

Now that the financial bubble inflated by zero and negative interest rates is being lanced, these balances are bound to diminish. We can see why this is the case just with onshore long-term securities, comprised of bonds and equities, to which we must add the estimated $10.7 trillion of eurodollar long term bonds. That’s $35 trillion in foreign-owned long-term investments in bonds and equities overhanging US financial markets, whose values are at risk from higher bond yields. Including additional offshore short-term deposits and foreign exchange positions in dollars, the total of $127.7 trillion is 175 times the foreign currencies held by US residents, available to absorb foreign dollar liquidation. This imbalance between foreign ownership of dollars and the availability of foreign currencies in US hands to absorb foreign dollar liquidation is simply staggering in its potential impact on the dollar.

The importance of this lop-sidedness cannot be over emphasised. A banking crisis, bear market in securities, geopolitical developments, or more likely some sort of combination of the three could lead to a rapid collapse of the entire American credit system. And the future of the massive dollar credit structure initially depends on interest rates and bond yields declining convincingly from current levels, and inflation remaining subdued. 

This is the stuff of dreams, not reality.

The interest rate outlook

As if aware of this danger, almost every broker’s analysis forecasts lower interest rates. This is a common view based on Keynesian and monetarist macroeconomic theory in the face of a widely anticipated economic recession. Keynesians argue that declining consumer demand leads to lower prices — a general glut — ignoring the fact that production output always declines first. And monetarists simply link a contracting money supply to prospective rates of price inflation. These mathematical theories dominate contemporary thinking and to an extent can act as short-term self-fulfilling prophesies, until the economic contradictions correct them — usually violently.

Both disciplines ignore the subjectivity factor, which is inherent in the value of any fiat currency that depends entirely upon the users’ faith in it. They have failed in their mathematics to adjust from the days when currencies’ values were anchored to real, legal international money without counterparty risk — which is only gold. Furthermore, they fail to understand the wider market realities of contracting commercial bank credit, which even under a solid gold standard makes up the vast bulk of a circulating medium. And they make the simple error of not understanding that in a recession it is not demand for credit which declines, leading to lower interest rates, but bankers perceiving heightened lending risk and restricting the availability of credit, leading to higher lending rates.

The reality is simple: if the banks restrict the expansion of credit, then borrowers face having to pay up in order to secure it. And to accommodate increased lending risk, banks widen their margins by increasing interest paid to depositors as little as possible. Does this not describe current bank credit conditions? So long as it remains the case, whatever investors and their brokers may desire interest rates will remain stubbornly high.

Nevertheless, the situation over bank credit does require more detailed examination, partly because regulatory changes have distorted money supply statistics. 

We must start with a simple definition of modern money supply: it is entirely comprised of credit in the form of central and commercial bank credit liabilities to members of the public and their businesses. But recently, the Fed has been taking in credit from money funds which would otherwise be recorded as bank deposits in public circulation. This has come about because under Basel 3 net stable funding rules, large deposits face a haircut of 50% for the purpose of funding balance sheet assets, compared with only 5% for small, insured deposits. And commercial banks are not prepared to cut their interest rate margins to compete for these deposits anyway.

Consequently, the Fed extended its reverse repurchase facility to money funds by using its stock of Treasury and agency collateral in exchange for money funds’ deposits. This has had the initial effect of reducing apparent money supply growth below what it would otherwise be, and then accelerating its decline when money funds reduced their repurchase positions in favour of treasury bills. To grasp the true situation, we must regard bank deposits and reverse repo balances holistically. The sum of bank deposits and reverse repurchase agreements is illustrated in the chart below.

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Between 2020 and late-2022, the increase in reverse repos served to conceal a far higher rate of growth in bank credit. In the belief that the crisis was temporary and having little option anyway, banks extended enormous quantities of credit; larger than unadjusted bank deposit statistics indicated on their own.

Most of the subsequent decline has been due to the fall in reverse repos, which have declined from $2.24 trillion in December 2022 to $681bn recently, while M2 itself declined by only $340bn over the same period. The funds tied up in reverse repos have since migrated to the T-Bill market, attracted by 1 month maturities yielding 5.4%. Essentially, they have disappeared into the government’s finances, doubtless further enhanced by banks switching their own loan books and bond holdings into short maturity T-bills in a general flight from lending risk. Additionally, total money funds have increased by about $1.4 trillion since last March to nearly $6 trillion all of which have also disappeared into T-Bills.

The extent to which the profligate Biden administration is sucking credit out of the US financial system is truly remarkable. While indicating that its own finances are in crisis, it shows that the level of risk aversion by the banking system towards private sector credit is considerably greater than generally realised.

While the credit shortage for the private sector is acute, a combination of money fund flows and banks de-risking their balance sheets has allowed the US Government to borrow $2.6 trillion since this time last year, allowing for changes in its general account at the Fed. These funds are leaking back into the economy through government spending, none of which is productive in the sense that it is freely demanded. In other words, far from being deflationary as the monetarists suggest, by being taken out of the commercial banking system and redirected into government hands the apparent contraction of the sum of bank deposits and reverse repos is actually a more inflationary deployment of credit.

It also explains why statistically nominal GDP is not declining to the extent indicated by anecdotal reports. 

These are precisely the credit dynamics which fuelled stagflationary conditions in the 1970s. At the time, the macroeconomic establishment was at a loss for an explanation. Today, establishment economists and investment managers are similarly clueless about the likely outcome of these credit conditions. Therefore, far from an outlook for stable, lower interest rates and bond yields, the opposite is in prospect. And with the economic outlook deteriorating, even tighter credit conditions for businesses and consumers and even greater unfunded government spending are in prospect. These stagflationary conditions are sure to lead to higher interest rates and bond yields, the failure of zombie corporations, systemic risks becoming apparent in the entire banking system, and a severe bear market in equities as well.

These conditions are sure to become increasingly obvious in the coming months. Less obvious is the role of collateral without which the entire credit structure collapses. It is worth spending a little time considering the threat from significant falls in financial asset values.

The role of collateral in the LDI crisis

What is generally not understood by the layman is that investments with inflated values underpin many over-the-counter derivative positions by acting as collateral. A problem inevitably arises when the value of collateral declines, triggering calls for additional collateral. The US banking system currently faces such as car-crash in commercial real estate, where the equity value is wiped out by current declines in value and banks are now faced with unsellable collateral. The problem is now widely publicised, but it doesn’t stop there.

This collateral value hitch attracted public attention in the UK when rising gilt yields threatened liability driven investment schemes, an example that we can use to improve our wider understanding of the role of collateral in derivative contracts, and the dangers presented by a collapse of the wider collateral system.

Liability driven investment (LDI) was being used by UK pension funds to enhance their returns. Defined benefit schemes faced with expensive final salary commitments to their beneficiaries were unable to meet these commitments from their investments when central banks reduced interest rates to the zero bound and through QE bond yields were suppressed to minimal levels. The only solution for these pension schemes was to enhance their returns through leverage.

Typically, this was being achieved through an off-balance sheet LDI scheme. It allowed a pension fund to protect itself from falling interest rates, which increases a pension fund’s future liabilities through net present value calculations. An LDI scheme provided leverage, so that the income on a gilt would be multiplied up to five or six times, allowing a pension fund to demonstrate actuarial cover for its future liabilities.

A pension fund investing in an LDI scheme effectively enters into a leveraged interest rate swap with the LDI provider. A rising interest rate imparts a negative value to the swap and the fixed income stream becomes worth less than the yield offered in the market. This requires the pension fund to put up further collateral to the LDI provider. And leverage multiplies the amount of collateral required. But pension funds tend to be fully invested, and not having the liquidity to hand were exposed to a radical increase in bond yields. 

The crisis was triggered when markets became spooked by Liz Truss’s proposed budget in September 2022. During her tenure, yields for the 10-year gilt rapidly rose from 3.88% to 4.5%, and for the 30-year maturity from 2.7% to 4.8%. In the latter case, during the crisis the value of this gilt fell by 13% in a matter of days. 

This forced pension funds to liquidate assets, including their gilts which is why the Bank of England had to step in to support the gilt market. And only when it was apparent that the authorities were buying gilts to stabilise their prices, panic among pension fund managers and LDI providers subsided. 

Subsequently, gilt yields rose to even higher levels, with the ten-year gilt yield hitting 4.75% last August and the 30-year 5.07% without the LDI panic returning. Obviously, that episode alerted pension fund managers to the dangers, and they will have addressed their LDI risk accordingly. But the same cannot be said for the wider use of collateral in international markets, for which the 10-year US Treasury note is the “risk-free” yardstick. 

The collateral problem is going global

LDI contracts are essentially interest rate swaps, exchanging a floating rate (in their case volatile gilt yields) for a fixed rate, usually enhanced through leverage. These characteristics are similar to those of the global interest rate swap market, which is enormous. According to the Bank for International Settlements, at mid-2023 it amounted to a nominal value of $465.9 trillion, of which $167.8 trillion is in dollars and $129.3 trillion equivalent in euros. 

Until the recent decline in bond yields, it had the potential to trigger a major crisis which probably would have required much more than central bank intervention, such as that deployed by the Bank of England in the case of LDIs. It was rapidly turning into a doom-loop, similar to that exposed by the UK’s LDI crisis, but involving the dollar, the euro, and all other major currencies. US banks were probably heading towards a trillion dollars in mark to market losses on their bond positions, and as borrowing costs continued to rise the damage to their P&L accounts from funding their bond holdings was increasing as well.

Perhaps this has persuaded the Fed to go easy on interest rate policy, the FOMC at last signalling that its fight against inflation is over and the battle to preserve collateral values has begun. But as noted above, the redeployment of massive amounts of money funds and bank credit from the productive private sector to the unproductive state is highly inflationary, undermining a currency’s purchasing power. Interest rates will have to rise again, or the dollar will weaken, or both. But higher interest rates will undermine securities’ values and lead to a new collateral and systemic crisis in the banks. And with the US and other economies facing a significant downturn, a balance between fighting inflation and maintaining asset values cannot last. While easing interest rates and bond yields have taken immediate pressure off currency and asset values, this will prove to be temporary.

One question this raises, is that in their long-term planning have the authorities foreseen a possible collateral crisis of this sort and taken advance action to deal with it in case it becomes reality? The answer appears to be in the affirmative. The question, but perhaps not the motivation is addressed in a recent book by David Rogers Webb, The Great Taking.[i]

The redeployment of securities in a systemic crisis

Webb’s analysis initially centred on the dematerialisation of securities from certificate form into book entry on the Depository Trust and Clearing Corporation. It is the forerunner of Europe’s Clearstream and Euroclear. These are central securities depositories, closely allied to central clearing counterparties. Without the investing public being aware of the implications, certificated property ownership of securities has been replaced with a “security entitlement”. 

The Depository Trust and Clearing Corporation also has a securities financing transaction clearing facility. From its website, we see that: 

“The SFT [Securities Financing Transaction] Clearing service introduces central clearing for equity securities financing transactions, including lending, borrowing and Repo to:

  • Support central clearing of institutional clients’ equity SFTs intermediated by sponsoring members.
  • Support central clearing of equity SFTs between full service NSCC members.
  • Maximize capital efficiency and mitigates systemic risks by introducing more membership and cleared transaction opportunities for market participants.”[ii]

This confirms that pools of collateral are made available to the entire system. We generally assume that this availability requires the agreement of those who have a claim on financial assets. But it is not clear that this is the case. Furthermore, the vast majority of securities are under the management and administration of regulated entities who can be leaned on by the authorities in the event of a crisis. The position is certainly not being made clear to the investing public. 

Since the US’s Uniform Commercial Code enacting these changes was introduced, other jurisdictions such as the European Union and UK have followed suit. Besides the erosion of owners’ claims on securities, the objective appears to be to give institutions and hedge funds the widest access to financial assets for collateral purposes. And where losses occur such as in a systemic failure, instead of the central securities depository taking the losses, it could be those who have replaced deliverable certificates with centralised registration: in other words you and me.

Undoubtedly, the framers of the Uniform Commercial Code would have had the protection of thinly capitalised exchanges in regulated markets in mind. We expect our transaction settlements to be guaranteed by them. But in a financial crisis leading to multiple counterparty failures, regulated markets cannot extend this protection. The solution appears to be to take this risk away from them and transfer it to central securities depositories, giving them the power to use the pools of securities under their control to ensure deliveries can continue under all circumstances. Not only does this facilitate securities lending, but it transfers systemic risk from regulated exchanges to pools of securities entitlements.

It appears that the corruption of security holders’ rights doesn’t stop there, as the Safe Harbour clause in US bankruptcy law legislation can also apply. The relationship between central securities depositories, such as the Depository Trust and Clearing Corporation, and central clearing counterparties such as a systemically important bank enables this to happen. 

In a test case in New York between Lehman Brothers creditors and JPMorgan Chase which acted as Lehman’s clearing agent, the creditors sought to reclaim $8.6bn from JPMorgan Chase.[iii] This was the amount which was seized by the bank despite it not being collateral in the days leading to Lehman’s failure. Prior to the seizure, it was an obligation to Lehman in the form of deposits and securities without a lien. Indeed, in the 92 page ruling, there were many references to the legal status of these obligations. Technically, JPMorgan defaulted on its obligation to Lehman’s creditors.

Clearly, without the safe harbour provisions in US bankruptcy law the seizure of these assets would have been illegal. This is the situation demonstrated under UK law, when JPMorgan’s London office was fined £33.32m by the Financial Services Authority in June 2010 for failing to ensure that client money, in other words funds which were custodial, was not properly segregated from the bank’s liabilities.

We learn two things from these different rulings. The first is that following the precedent of the US court in New York, JPMorgan has the power to ignore the distinction between assets held as collateral and assets which the bank has an obligation to discharge to a depositor. And secondly, this US bank, which happens to be the largest and the Fed’s primary conduit into commercial banking has failed to distinguish between that relationship in US law and its legal and regulatory obligations in other jurisdictions, such as the UK.

Nowhere is this more important that when it comes to the custody of real legal money, which is gold. But there are indications that custodial vaulted gold held by the largest physical ETF (GLD) might get caught up in this quagmire as well.

JPMorgan’s relationship with gold

At the outset, it is worth noting that regulatory bodies tend to give large banks the benefit of the doubt, only looking closely at their compliance activities when they can no longer be ignored. Consequently, large banks have been known to act as if regulations don’t exist. The example above, where it was absolutely plain that JPMorgan Chase was in breach of the regulations with respect to custodial client money in London may or may not have been an exception. But we are entitled to assume that some of the smartest lawyers and compliance officers are employed by JPMorgan Chase and who should have known better.

This lack of respect for the law was demonstrated in an important case in the gold market, when JPMorgan Chase’s global head of precious metals trading and a board member of the London Bullion Market Association was found guilty of attempted price manipulation, commodities fraud, wire fraud and spoofing prices in gold, silver, platinum, and palladium futures. And it is not as if this was an isolated case: it had been going on for eight years involving thousands of unlawful trading sequences. And another colleague heading up the New York gold desk was also found guilty. That was in July 2019. Finally, in 2020 the bank itself pleaded guilty to unlawful trading in precious metals futures markets and was heavily fined.

Inexplicably, with this track record JPMorgan Chase Bank was recently appointed joint custodian of SPDR Gold Shares (GLD) alongside HSBC. This ETF is the largest in existence by far and its sponsor is a subsidiary of the World Gold Council. Why the WGC sanctioned the appointment of a bank whose senior dealers in precious metals have been found guilty of manipulating gold prices and jailed is a mystery. It is not as if having one custodian represents more risk than two. Furthermore, HSBC stores all GLD bullion in its London vaults, so that it is subject to English property law and securities regulation in every respect.

JPMorgan Chase is reported to be considering the transfer of GLD’s bullion to its vaults in New York. It is thought that their vault is linked underground to the Fed’s vault, with the Fed on the north side of Liberty Street and Chase Bank across the road.[iv] It is in this context that we return to David Webb’s analysis of central counterparties, ownership of securities as property being replaced with a “security entitlement”, and the free use of that security entitlement as collateral without the knowledge or agreement of the entitled. And according to the ruling of the New York court effectively extending this facility to JPMorgan Chase as a central clearing counterparty, we may be assembling a picture which will allow JPMorgan Chase to use GLD’s bullion as collateral, or perhaps to lease or swap it, or alternatively to dispose of it in return for a book entry credit.

Our suspicions will be increased when we think through the implications of the proximity of JPMorgan Chase’s vault to the Fed’s vault across the road and circumstantial evidence of a connecting tunnel between the two. Stored in the Fed’s vault is gold on behalf of the New York Fed earmarked for foreign central banks. And when we remember the difficulty Germany had getting the New York Fed to return a paltry 300 tonnes, doubtless our suspicions will go into overdrive.

Undoubtedly, GLD’s trustee The Bank of New York Mellon and the World Gold Council have some serious questions to answer as to why JPMorgan Chase was appointed a custodian. Here are just a few suggestions:

  • Did the Trustee of the World Gold Council come under pressure from any government organisation or monetary authority to appoint JPMorgan Chase a custodian to the SPDR Trust?
  • Were the Trustee and Council not aware that JPMorgan Chase has a history of market manipulation in gold contracts, and that the bank had pleaded guilty. According to the Office of Public Affairs in the US Department of Justice: “In September 2020, JPMorgan admitted to committing wire fraud in connection with: (1) unlawful trading in the markets for precious metals futures contracts; and (2) unlawful trading in the markets for U.S. Treasury futures contracts and in the secondary (cash) market for U.S. Treasury notes and bonds. JPMorgan entered into a three-year deferred prosecution agreement through which it paid more than $920 million in a criminal monetary penalty, criminal disgorgement, and victim compensation, with parallel resolutions by the Commodity Futures Trading Commission (CFTC) and the Securities Exchange Commission announced on the same day.”[v]
  • Furthermore, that two of their senior staff were on trial when JPMorgan Chase was appointed custodian, one of which served on the board of the LBMA and ran JPMorgan’s global precious metals desk, and the other an executive director and trader on the New York precious metal desk? And that both men were subsequently jailed and fined for market manipulation in August?[vi]

Almost certainly, the Trustee and the World Gold Council’s management won’t be called upon to answer these questions. But the legal position of GLD shareholders’ underlying property assets appears to be compromised by these developments. So far, only 1,824 LBMA 400 ounce bars out of a total of 34,818 GLD bars are in possession at JPMorgan (15 January). But if the bar total begins to increase materially, it will be interesting to observe the extent to which they are added to JPMorgan’s custody, and the extent to which that accumulation is in its New York vault.

Furthermore, authorised participants can borrow their shares from a centralised securities depository and redeem them for physical gold. By hedging their position in futures or London’s forward markets, they are under no pressure to return the gold and close their stock loan. Given this facility, far from GLD being a secure investment in gold bullion, it is already being used as a source of liquidity for bullion banks.

How the end game plays out

A credit crisis is looming — for the moment deferred by widespread hopes that interest rates will decline this year, allowing bond yields to stabilise, it is hoped at lower levels. The moment it is realised that there is no further downside in interest rates and bond yields, a crisis in equity markets will ensue.

The chart below illustrates the disparity which has built up between bond yields and equities. The relationship is already very stretched and unlikely to survive the prospect of long bond yields going no lower.

The run on equities could well start with foreign selling of the some $14.5 trillion invested in US equities. The overhang of foreign interests in dollars and dollar assets is over four times US GDP, and what is not lost to lower values is sure to result in dollar liquidation, driving interest rates even higher as a currency collapse beckons. And it is unlikely to be just a matter of a nasty bear market because of the central role that financial collateral plays in the banking system and the massive structure of derivative obligations.

We had a foretaste of what can happen when liability driven investment schemes in the UK were undermined by rising yields, forcing pension funds into liquidating their gilt holdings. It is potentially a global problem, which will almost certainly return to haunt us when interest rates begin to rise again.

The way in which the authorities will deal with it will require their greatest levels of imagination yet. In the name of protecting us all, one possibility is to insulate regulated exchanges and their institutional users from a systemic crisis by giving them access to additional collateral, ultimately the possession of ordinary investors — that is you and me. And it appears to not stop there. Anyone who buys into gold ETFs, particularly GLD might think they have insurance against a credit crisis. They would be mistaken. It appears that through JPMorgan and the proximity of its New York vault to that of the New York Fed’s on Liberty Street and the former’s surprise appointment as a second custodian will give the US authorities access to GLD’s bullion held on behalf of its shareholders.

And lastly, it was Irving Fisher who in the 1930s pointed out that falling collateral values lead to credit liquidation and yet further falls in asset values in an unbreakable doom-loop. That is the chaos we may face, made worse by high bank leverage, unproductive lending to governments and zombies, excessive consumer debt, and a mountain of foreign ownership of dollars and dollar assets. Yet so delusional we have collectively become that we don’t understand the importance of owning in our own possession or vaulted outside the banking system the one store of wealth with no counterparty risk — GOLD.

[i] Available online here: 

[ii] See 

[iii] See 

[iv] See Ronan Manly’s article at 

[v] See 

[vi] Ibid.