SPECULATIVE DERIVATIVES ARE ABOUT TO COLLAPSE

The most powerful building in the world.

Speculative derivatives markets are in the process of collapse–with serious consequences for us all. This will eventually have broad-reaching ramifications for every sector of business, not least of which is in valuations for bankruptcy proceedings and other court proceedings.  

Directly and heavily impacted will be the insurance industry.  Insurers with significant exposure to speculative derivatives include: Lincoln National Corp., Ameriprise Financial, AIG, Prudential Financial, and Voya Financial.

This is a problem that has been brewing since Sept. 16, 2019 with break-down of the Federal Reserve’s overnight repo market.  Months later, even with massive Fed repo injections, commercial paper purchases by the Federal Reserve, announcement of $800 billion Fed QE program, announcement of $1 Trillion IMF QE program and a Fed Discount Window rate cut to .25%, the US and European equity markets opened the day limit down–which triggered circuit breakers to temporarily stop equities trading.

How does this affect every-day Americans? It may take a few months to play out, but oncoming crash of speculative derivatives will touch just about everyone in this country.

Unfortunately, it probably means that anyone expecting financial security from a life policy or annuity contract from, at least, Lincoln National, Ameriprise, AIG, Prudential or Voya faces a rough road ahead.

Further, everyday Americans depend on health insurance for illness coverage. In addition, annuity coverage, together with 401k arrangements, provide the expected lifeblood for survival for millions of Americans.

Will my health insurance be there when I need it? Will my annuity payments continue as expected? Will my life insurance pay out in the event of death? To be sure, government can provide stop-gap benefits for a short period, but cannot provide a permanent security solution for Americans and American families and businesses.

The core of the financial crisis of 2008, and again today in 2020, has been the derivatives trading / insurance markets. This post gives our view of the derivative trading and insurance markets–what is going on with derivatives, how bad will it likely get. In future posts we will examine the impact of these derivative trades on specific insurance markets: particularly life and health.

Speculative Derivatives 101

Derivatives are essentially contracts that reference an underlying obligation–typically a bond or futures contract or a trading index. Derivatives can be used either for risk management (i.e. for a commodity “hedge”) or for speculation (i.e. making a financial “bet”). This distinction is important.

For example a prudent airline will typically hedge against a rise in fuel prices to manage expected future expenses and thereby properly price airline tickets. This is an example of a derivative used for sound management purposes.

However, since about 1999 (coincident with repeal of the Glass-Stegal Act) large banks have used speculative derivatives to lever up trades with ever-higher leverage. These are the problem instruments that caused financial destruction first in 2008, and again today, in 2020.

Unregulated Derivative Trades: A Recipe for Disaster

The trigger for the 2008 meltdown was mortgage-backed securities, while the trigger for the current (2020) market crisis seems to have been the corona virus. But as with any large explosion, the trigger, or detonator, is just the spark that ignites a keg of dynamite, which then explodes. In this analogy, corona virus (2020) or mortgage backed securities (2008) are the trigger (detonator)–while the keg of dynamite are the global base of derivative financial instruments and their complex inter-relationship of counter-party insurers.

No one has an accurate estimate of the total size of the global derivative markets, since so many derivatives are traded and insured in private (OTC) transactions away from the view of public markets, but most estimates place the amount of global derivatives at roughly $750 trillion, in “notional” amount. $750 trillion. Let that number sink in.

The Problem With Current Risk Models

Wall Street traders assume, and are quick to argue to regulators and the public, that the total notional value of speculative derivatives needs to be “netted” out in order to assess risk. This means, for example, that if an underlying bond has a face (notional) value of $1 million; while ten derivative trades betting on performance of this single underlying bond also have a face (notional) value of $1 million each, then the face values of each instrument over and above the underlying amount ($10 million total in the above example) must be netted out. Wall Street traders firms only count the face value of the underlying instrument in assessing risk. This netting process may reasonably assess risk in smoothly-functioning capital markets, since the underlying obligation is paid, and counter-party insurers are thereby released from their respective guarantee obligations; the underlying debt just goes away.

But this risk-netting process used and advocated by Wall Street completely breaks down in times of capital market distress. When underlying obligations are not timely paid, demands are thereby made on each respective counter-party; and if enough obligations remain unpaid, the counter-party finds itself in a position of being unable to pay all counter-party claims. This is precisely what happened, infamously, to AIG in 2008, as most people know–and is starting to happen again today (2020).

Too many Sticks of Dynamite

The problem with Wall Street’s risk-netting process for speculative derivatives is that each new derivative contract is like adding an additional stick of dynamite to a larger pile. During smoothly-functioning capital markets, the first stick of dynamite is increased by ten more sticks. Without a detonator, the dynamite remains in a safe condition and no harm is done. When the underlying obligation is paid, all 11 sticks of dynamite are removed, and all is well.

Further, if a single stick of dynamite blows up (say, the underlying instrument goes unpaid), a relatively small problem exists–a problem that can probably be repaired. However, if ten additional sticks of dynamite are added to the pile, and THEN the underlying obligation goes unpaid…well, then we have a problem: we have a live pile of dynamite sticks in a dangerous condition. And if a trigger (detonator) is added to the mix and we have an explosion of 11 sticks of dynamite–a much bigger problem exists.

Wall Street’s risk-netting model counts only a single stick of dynamite, while assuming the other ten sticks simply do not exist.

Does Wall Street’s risk-netting model make sense? Wall Street’s model only functions in smoothly-functioning capital markets. When capital markets breakdown, an explosive condition exists, that can be triggered by any number of potential detonators. So when markets are in distress, Wall Street’s risk-netting models makes absolutely no sense whatsoever, and are dangerously irresponsible.

So what should the correct risk-assessment model be for speculative derivatives? The correct model for risk, according to leading experts, is to ADD all risk related to speculative derivatives. Using the example above, this means we can only assess risk of market collapse by ADDING all 11 sticks of dynamite–something Wall Street analysts refuse to recognize.

Complexity Theory

The risk model suggested above–add all 11 sticks of dynamite to assess risk instead of assuming only 1 stick of dynamite–is at the heart of newly-developed science called “complexity theory.” Complexity theory is routinely used to estimate the direction and velocity of hurricanes–attempting to account for the large directional changes that may occur with small inputs. Meteorologists routinely rely on complexity theory models, recognizing they model reality far better than outdated models based on calculus and stochastic theories.

So is a society, or a capital market at least as “complex” as a hurricane? Yes–certainly–absolutely. The way members of a society interact with one another, and the impact these interactions have on the capital markets must certainly be one of the most complex systems in our world today.

Notwithstanding, complexity theory modeling has not been well-received in mainstream financial circles, or by economists; possibly because it reveals that much economic research for the past 50 years is irrelevant and deeply-flawed–something no economist wants to admit, and no trader may want to acknowledge. But complexity is the only way to understand the dynamics of feed-back loops through social and economic actions–and the only way to accurately assess risk in today’s capital markets.

A formal property of complexity theory is that “the size of the worst event that can happen is an exponential function of the system scale.” So in our example of dynamite above, the worst thing that can happen is 11 sticks of dynamite blow up–not just one stick. In our modern economy, the global derivatives risk is that $750 trillion of derivatives cannot be paid–and thereby blow up. A complete or partial system failure will occur–something obvious to all. And this is where we stand today, March 15, 2020, as we stare into the abyss of the disaster looming in the capital markets–a disaster caused by unregulated derivative traders and insurers.

What to Do?

What to do about the looming system explosion threatened by derivative instruments (triggered, in part, by coronavirus) is to understand and accept the reality of this unacceptable solution. Anyone who still thinks that the Federal Reserve or Congress, or the IMF or Brussels, has a magical “tweak”, while still allowing unregulated derivatives, may want to carefully re-think that view.

There will be time ahead to design concrete solutions for system recovery and prevention of future such problems. Ideas will be offered in future posts on this site. Certainly it will be important for Congress to outlaw, completely, speculative derivative trading.

But step one at the present moment, as in any crisis, is to acknowledge and accept the likely new reality in which we now live. Financial derivatives are about to explode–with serious consequences for us all.

speculative derivatives