-- Posted Sunday, 23 April 2006 | Digg This Article

In the late 90’s I moved to London, England.

One of the legacies of the British Empire was to extend reciprocal work visas to former colonies. It was a way for the Imperial Mothership to continually access cheap labor. The result was to encourage Highly Trained 20-Somethings from Canada, Australia, South Africa and New Zealand to work in the City.

Basically, for the 20-Something, it was a license to PARTY and TRAVEL.
In the late 90s, the Internet BOOM was in FULL force. Money was flowing like water. I was 25, newly married and highly qualified; there were few better places to be in than London!

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For most BIG banks there are 2 maybe 3 Cities where they MUST maintain a presence. The first is obviously New York. The second London. And the Third Tokyo.

US operations are normally so BIG that New York is the center of all things North American. The rest of the World is pretty much covered off by the London Office.
The Tokyo office was usually set up in the 80’s to take advantage of Japan’s Incredible Boom. Nowadays, I think the Tokyo office is a valuable springboard into all-important Far East but even more significantly, a source of Ultra-Cheap Money vis-à-vis the Yen Carry trade.
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For my part I got a job at a Blue Chip American bank in their Derivatives area.
The amounts we dealt with were off the charts. I remember how I worked on a project to fix the mainframe. One of the number fields had run out of space and we needed to add the capacity to enter a few more Zero’s. No Kidding! Notional values (the value the derivative is based on) ran into the Hundreds and Thousands of Billions.

The MTM (mark to market) numbers were also Titanic. MTM is the actual gain or loss on the derivative on a given day. MTM is calculated daily and the gains or losses settled each day with the counterparties.

I honestly don’t know how they ever settled the MTM’s. Firstly, we had more than one pricing engine which often Valued the same contract differently.
At around 4pm everyday our system would automatically Fax off position advices and Wire or Withdraw the differences from counterparties bank accounts. Since our Back Office had a MASSIVE reconciliation problem, it wouldn’t surprise me if a few Million $ arrived in someone’s bank account completely unbeknown to them.

From what I could understand most counterparties were banks themselves. They had similar accounting and pricing problems so it was accepted that things would balance out over time. Yikes!

A Derivative is like an Onion. The Derivative Structurer tailors the pay-offs to meet their clients needs by adding level upon level of different Derivative Products. It’s this service which makes the products so expensive and earns HUGE cash for the banks. From what I saw, most derivatives are used to:

• Dodge Tax
  
• Manipulate Profits
  
• Gamble
  
• Hedge
  

A popular product at the time was a DAX Equity Swap. Apparently German investors had to pay some kind of stamp duty when they held equities outright, however if they held an Equity swap issued by a Non-German entity (the pay-off was exactly the same) there was no Tax.

Derivatives can and are used to manipulate profits. A very simplistic explanation of this would be for one entity to sell out of the money Call Options to another entity. The expectation is that the Options would never be exercised so the writer gets additional Income via the premium and the purchaser gets a Tax deduction when the Option expires worthless.
What happens if the market moves against the position?
Easy, you continuously Delta Hedge or Sell the client additional products to balance the cash flows appropriately.
Sure, it’s not riskless but it works more often than not. And the BANKS make a TON of cash out of it.

After the Bond market, the Swaps market is probably the most liquid in the world. The Big Institutions are the Market Makers and privy to an enormous amount of valuable information. The incentive to Speculate is huge. A’la the BIGGEST CASINO in the WORLD.

There are legitimate uses for Derivatives as well:

• Credit Default Swaps (insurance against Credit Risk) were popular in the late 90’s because of the Long Term Capital Management debacle.
  
• Forex Swaps
  
• Mortgage Backed Securities where the pay-off from a group of mortgages is swapped for a Fixed Rate. These must be the Grand Daddy of Derivatives today because of the Real Estate Bubble.
  
• Interest Rate Swaps, the Biggest Market at the time (and may still be), is a valid tool to shift interest rate risk around.
  

Ofcourse it always comes down to the same thing, the Credit Worthiness of the Counterparty. Like Jim Sinclair says, it’s a Daisy chain so you’re effectively at the mercy of everybody in the market to honor their debts. And ofcourse sooner or later someone is going to default.

Commodity Derivatives

There was a fair share of Energy and Metal Swaps on the Books. But lets be honest, they were so infinitesimally small compared to the other products. And this was the Booming 90’s. Nobody was interested in Oil at $10 or Gold at $250 least of all Me!

I never saw a Gold Swap contract but I’m pretty sure the Banker Boys allowed Cash Settlement in lieu of Physical Delivery.

Greg, that’s a great story but why is it relevant to us today?

There is a Raw ingredient that goes into every derivative contract. It’s the ‘Risk Free’ Treasury Note. Otherwise known as the Risk Free rate of return. ON BALANCE, over the last 20 years, every derivative written has, as its raw ingredient, an ever-declining risk free rate of return.

That’s now changing!

It is quite likely that the 20 year Bull market in Treasuries is now over and ON BALANCE rates will be heading higher over the next 20 years. This adds subtle but definite stress to the derivative mountain. As the whole structure becomes more expensive to maintain counterparties of questionable creditworthiness will start to DEFAULT (if that’s not happening already).

This Derivative thing is an absolute MONSTER.
It dwarfs almost everything else in Size and Impacts on every Financial market.
THERE IS NO WAY THAT THE CENTRAL BANKS WILL LET DERIVATIVES SINK THEIR GRAVY TRAIN. Whenever a "Derivative Problem" crops up, Central Banks FLOOD the system with liquidity and that means ever-expanding Money Supply.

In fact we have seen quite clearly that the markets, ALL markets, LOVE increased liquidity and have shown no signs of caving in because of it.

The catalyst which WILL cause Financial Markets to CRASH (and Gold to Soar) will be EXOGENOUS to the markets. It will cause an Upward re-rating of Inflation expectations in the Publics eye. And that my fellow readers will be courtesy of our Commander-In-Chief, Iran, Al Qaeda or every other Terrorist organization that will help expand the War in the Middle East later this year.

My experience in the City of London has convinced me that Derivatives will NOT be the catalyst for a Financial Collapse. But it will make one Infinitely more powerful!


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-- Posted Sunday, 23 April 2006 | Digg This Article

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