-- Posted Friday, 24 October 2008 | Digg This Article
| Source: GoldSeek.com
DEEPCASTER LLC
www.deepcaster.com
DEEPCASTER FORTRESS ASSETS LETTER
DEEPCASTER HIGH POTENTIAL SPECULATOR
Wealth Preservation Wealth Enhancement
Financial and Geopolitical Intelligence
The $55 Trillion Dollar Collateralized Debt Securities Market is:
“Completely lacking in transparency and completely unregulated”
Chris Cox, Chairman U.S. Securities and Exchange Commission, October, 2008
“Charlie and I are of one mind in how we feel about derivatives and the trading activities that go with them: we view them as time bombs, both for the parties that deal in them and the economic system.”
“…The derivatives genie is now well out of the bottle, and these instruments will almost certainly multiply in variety and number until some event makes their toxicity clear…”
“…In our view, however, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.” (emphasis added)
Warren Buffet, February 21, 2003
“The chain broke in the CDS market when Lehman Brothers went down. We may now see other counterparties defaulting, said Andrea Cicione, Credit Chief at BNP Paribas”
“With hindsight, it is now clear the decision to let Lehman Brothers go bankrupt set off a meltdown of the world financial system, forcing North America, Britain, Europe, Australia, and now parts of Asia to rescue their banks. “A dramatic error” said Christine Lagarde, France’s Finance Minister.
Ambrose Evans-Pritchard, The Telegraph, London, October 16, 2008
“Indeed, the entire Financial Structure is only as solid as the balance sheet of the weakest link in the Dark Derivatives parties and counterparties Daisy Chain.”
Deepcaster, February 29, 2008
We consider again how the exponentially increasing proliferation of Dark OTC (over-the-counter) Derivatives is dramatically increasing Systemic Risk and what steps can be taken to protect and potentially profit from this proliferation.
Generically speaking, a “derivative” is an entity whose value is derived from the value of some other entity. Hence the term “derivative.”
In the context of the financial markets, derivatives are Special Performance Contracts between two parties often called ‘party’ and ‘counterparty.’
Though there are many kinds of derivatives, three of the most common are stock options and commodities and financial futures options. A futures contract itself is a derivative – some refer to this as a first order derivative. An option for a futures contract is a second order derivative. In other words, its value is derived from a first order derivative (the underlying futures contract) which has its value derived from the underlying commodity involved be that corn, wheat, cocoa, etc. Similarly, financial futures contracts on currencies, Treasury Securities (T-Bonds, Notes, etc.), and Equities Indices are derivatives also.
One of several primary reasons that financial institutions and others engage in derivatives transactions is because of “leverage.” Leverage simply gives the holder of a derivatives contract an opportunity to make profit in the order of magnitude of many hundreds of percent more than the amount capital he put at risk. On the other hand, derivatives contracts often give one party to the derivatives contract risk of similarly high multiples of liability which, at times, can approach becoming unlimited liability.
Derivatives transactions are typically a “zero sum game.” One party’s gain is the other party’s loss.
The foregoing suggests one major incentive for derivatives creation: profit. (And there are other incentives, e.g. ostensible hedging against losses.)
But suppose a counterparty (on the losing side of a derivatives contract) cannot pay?
OTC Versus Exchanged-Traded Derivatives Contracts - - A Crucial Distinction
The foregoing question highlights a crucial distinction between Exchange-Traded Derivatives Contracts whose performance is guaranteed by a Clearinghouse and Over-The-Counter derivatives contracts (OTC) whose performance is typically NOT guaranteed by an entity other than the contracting party and counterparty.
That difference is a huge difference for several reasons. For example, note that Exchange-Traded Contracts (such as typical futures contracts for corn, wheat, crude oil, gold, Treasury Bonds or the U.S. Dollar via the USDX) are visible and somewhat public (being traded in a public market), and, typically, Clearinghouse guaranteed. That is, if one party to an Exchange Traded Contract defaults, the Clearinghouse in on the hook to make good on that contract, if the counterparty fails to make good on it. This provides extra layer of security both for the parties to the contract and, importantly, also functions as security for the entire market in Exchange-Traded Derivatives Instruments.
On the other hand, OTC derivatives are far more risky and far less transparently visible (if visible at all!) to the public than are Exchange-Traded Contracts. OTC derivatives are a form of “Dark Liquidity” since their existence and terms are often known only to the party and counterparty (see Deepcaster’s Alert of 4/18/07 “Profiting from ‘Dark Liquidity’ and Other Systemic Risks” at www.deepcaster.com.)
Dark Liquidity and Dark Pool Derivatives Transactions
Consider the characteristics and risks of “darkly liquid” OTC derivatives transactions often conducted by large institutions in “dark pools” (i.e. not in a public market).
These Dark Pools are typically “completely lacking in transparency and completely unregulated as SEC Chairman Cox noted (above).
The significance of “dark pool” transactions cannot be underestimated - - a recent estimate is that 10% of all equity transactions occur in “dark pools,” and that this number is growing.
One may obtain information about such dark pools from finextra.com or financetech.com websites, for example. For those not inclined to visit these websites to read the very revealing articles, the following excerpts taken from those websites in April, 2007 and February, 2008 will provide a sampling of the import of ‘dark liquidity’:
‘Dark algorithms,’ et al… (JP Morgan’s) “Neovest has established connectivity to 15 ‘dark pools’ of liquidity - - trading networks that do not publish quotes in the open market…”
“Neovest currently provides access to over 100 broker destinations and a range of dark pool algorithms….”
Regarding Goldman Sachs new platform “…the new platform will provide customers with access to deals that are not offered publicly on any exchange…(to) provide clients with access to dark liquidity pools.”
Regarding the ITG ‘dark liquidity crossing platform,’ “the system’s total anonymity ensures that there is no leakage of information into the market and therefore price impact is minimized, says ITG.” (emphasis added)
Regarding dark liquidity pools run by ‘dark book’ algorithms: “Earlier this year electronic broker Instinet launched a ‘stealth liquidity aggregation algorithm’ called “Nighthawk” and “JP Morgan Chase has launched Aqua and Arid, two institutional trading algorithms that have been designed to stealthy trade stocks on dark books - - trading networks that do not publish quotes in the open market…”
(all excerpts above from April, 2007)
Apparently, despite the increasing problems with “dark liquidity” derivatives, at least some of the major institutional players recently (i.e. in February 2008) still savor playing in this “dark” arena:
“Turquoise enters testing phase”…the turquoise exchange” will begin trading in 300 liquid stocks in September and gradually roll-out to encompass 1200 stocks in a “darker liquidity pool” (emphasis added)
finextra.com, February 14, 2008
Systemic Risks from Dark Liquidity in Dark Pools
Deepcaster, and others, have long warned about the risks of darkly liquid OTC Derivatives. Consider Deepcaster’s “Laundry List” warning of February 29, 2008:
- - “In considering ‘dark liquidity,’ ‘dark pools,’ ‘dark algorithms’ and such, Deepcaster’s initial reaction was “what about the ‘Theology’ of the free and open and fair marketplace with a level playing field” with which we are inculcated?” And “what about the risks?” Don’t all these ‘dark vehicles’ greatly increase the risks in the market?
- - And do they not also provide manifold opportunities for The Cartel* to implement Market Interventions without scrutiny? Consider:
- - It is pretty clear that the ‘dark pool algorithms’, which are at the heart of systems designed to trade large orders in liquid markets, enable automated trading operations otherwise known as “program trading.” But haven’t automated trading platforms played a big part in major company and market meltdowns?
- - Isn’t an essential part of any investors’ sensible risk evaluation a function of evaluating counterparty risk? That is, counterparty is the party who takes the other side of any particular investment transaction in which any of us is involved. But the capacity to make good on any such transaction is typically solely a function of counterparty strength or weakness. In OTC dark liquidity transactions there is typically no clearinghouse guarantee. Suppose the counterparty fails? And suppose the counterparty on any particular investor transaction is at great risk because of its ‘dark book’ transactions with other ‘dark’ parties. Who would know, and how could the risk be evaluated?
- - Indeed, we certainly have enough recent examples of Counterparty Failure to cause concern. Consider Lehman Brothers and the Amaranth Hedge Fund in recent months and Long-Term Capital Management in recent years are only three examples of this.
- - And what about “Fundamental Fairness” and “Level Playing Fields” in The Markets? Equal timely access to price information is essential to fairness to the investing public, but “dark pools” and “dark transactions” in principle limit such information to the privileged few!
- - And what about “conflicts of interest?” One blogger wrote: But if a bank sets up an (dark pool) exchange, some of the biggest traders on the exchange will also be the bank’s biggest customers in other areas. This is a massive conflict of interest situation. Remember what happened in the 1990s when investment banks noticed that their equity research divisions could be used as a marketing tool? Imagine using execution speeds and pricing for the same purpose.
- - And what about lack of oversight? Who is watching the watchers, if indeed there are any watchers?
- - And what about the potential for fraud?
The “Daisy Chain” Default Risk Comes Home to Roost
The lack of transparency, in dark liquidity pools and dark books, lack of the ability to evaluate counterparty strength, conflicts of interest, and the ongoing credit bubble and housing bubble bursting certainly continue with increasing intensity to ravage the financial system and portfolios.
And there is the rub. The failure of one firm has a cascading effect on countless others because of the way the risks are offset to numerous other parties and counterparties. Think Lehman Brothers and Enron.
Derivatives Monsters’ Magnitude
Yet the amount of OTC derivatives outstanding was nearly $600 trillion as of December, 2007, according to the Bank for International Settlements (BIS – the Central Bankers Bank)! See www.bis.org, follow the path: statistics>derivatives>Table 19 and ff.
No Sector Immune From OTC Derivatives Risks
The multiplying institutional failures demonstrate no sector is immune from derivatives risks. As we are learning, the massive risks associated with OTC derivatives are laced throughout the financial system.
Indeed, just a few months ago who would have thought that the Big Pharma company Bristol Myers Squib would have to take a quarter of a billion dollar write down as a result of its derivatives transactions. And who would have thought they would have to give “guidance” that more write-downs might have to be made? Thus, it is not surprising that Warren Buffett called derivatives “toxic…financial weapons of mass destruction.”
Indeed, consider the following data on OTC derivatives creation and the troubling acceleration of their creation.
Over The Counter (OTC) Derivatives – Accelerating Creation, Increasing Risk
Consider the import of the Derivatives Data from the BIS' own website - - Review Table 19 at www.bis.org. Follow the path: Statistics>Derivatives>Table19. Note that as of December, 2007 there were:
- $9 trillion Commodities Contracts (excluding gold) outstanding
- $56 trillion Foreign Exchange Contracts outstanding
- $393 trillion Interest Rate Market Contracts, outstanding
If one compares the December 2006 with the December 2007 figures one finds stunning increases in OTC Derivatives in just the twelve months between December, 2006 and December, 2007.
The Massive Interventional Risk
Gold and Silver are the Mortal Enemies Number One of The Cartel’s Fiat Currencies and Treasury Securities because they are competitors for being Ultimate Stores and Measures of Value. As such, they are at great risk of repeated Takedowns, such as those which Deepcaster correctly Forecast and chronicled regarding the March, 2008 Crisis and the June, 2008 Takedowns (and several Takedowns in prior years as well). See Deepcaster’s July 2008 Letter “Market Intervention, Data Manipulation Still Accelerating: Increasing Systemic Risks, Cartel “End Game” Threatening” in the Letters Cache at www.deepcaster.com for an overview of The Interventional Regime.
Does The Cartel still have the firepower to effect another Major Takedown? Consider that The Cartel has over $1 trillion in Gold Derivatives Contracts available to move the Gold Market alone (see Deepcaster’s July 2008 Letter and the Bank for International Settlements Triennial Survey at www.bis.org, Path: statistics>derivatives>Table 19 and ff.). If the Equities Markets and Crude are to be further taken down, from The Cartel’s perspective, it must attempt to prevent investors from “escaping” to Precious Metals.
Thus the Financial Markets’ Question of the Decade is: Will the Cartel be able to successfully continue its Market Interventions in the face of ever more potent negative fundamentals? Whether or not it does, Deepcaster has developed a strategy for “Defeating the Cartel… with Profit,” in the Articles Cache at www.deepcaster.com.
The Meltdowns Continues
We have already seen several negative consequences of the proliferation of OTC derivatives (Dark Liquidity) throughout the financial system. Two of the most salient are the ongoing mortgage default debacle and the ongoing credit market freeze-up, which first became publicly apparent in August, 2007.
It is not surprising that the proliferation of darkly liquid OTC derivatives should result in a credit market freeze-up. After all, who knows, for example, whether a “package” of Collateralized Debt Obligations that a financial institution is considering buying contains some securities on which the counterparty/ies is/are about to default?
No to oversimplify too much, it is this characteristic of “darkness” which was and is a primary cause of the credit market freeze-up beginning in August, 2007. Institutions are reluctant to lend because they do not trust each other’s books, or what is even worse indeed, they sometimes do not understand what is on the books! They are but darkly intelligible because they are based on computer models, dark algorithms and assumptions. But that is the very thing that works to kill confidence when no one can understand who has what. The consequence: lending institutions do not want to lend because they cannot get a clear handle on the strength of the balance sheet of the firm they might be lending to. This crisis continues.
The response of the U.S. Federal Reserve (a privately owned for-profit entity) has been to increasingly liquefy the banking system by, inter alia, providing even more (borrowed) liquidity via a discount window and reducing rates.
But there are Great Systemic Perils which arise from creating ever more “borrowed liquidity” (the approach preferred by The Fed) versus the healthier “earned liquidity” (e.g. savings) on which Deepcaster has commented in his January, 2008 Letter “Market Intervention, Data Manipulation, Increasing Risks, The Cartel End Game, and Latest Forecast” and in “Profiting From Dark Liquidity and Other Systemic Risks (4/8/07 Alert at www.deepcaster.com).
The core of the Systemic Problem and increasing risk is that beginning after the Tech Wreck of 2000, the Fed-led Cartel* of Central Bankers created and allowed far too much borrowed liquidity (i.e. debt) to be created, creating the credit bubble and the mortgage bubble. And this excess liquidity creation continues to this day - - M3 is increasing at more than 14% per year, about a 5 year doubling time, according to shadowstats.com!
Of course, it was and is in the interest of the private-for-profit Fed to create and then allow the bursting of these bubbles as we explain in our recent article “Profitably Avoiding the Fed’s New ‘Inflation Tax’ & Coping with The Power Grab” (in the Articles Cache at www.deepcaster.com).
Thus the realities of Intervention and the marketplace are causing these bubbles now to be in the process of being punctured, resulting in increasingly negative consequences and increasing Systemic Risk for the financial markets and the broader economy, as well.
Object Lessons - - A Harbinger for the Future
“But for systemic intervention and manipulation by the Federal Reserve, it appears we might be contemplating a collapsed U.S. banking system and a looming deflationary great depression that could have dwarfed the bad times of the 1930s. Such is the good news. The bad news is that with those same systemic interventions, the Fed is locking in a hyperinflationary great depression in the decade ahead, with the turmoil possibly breaking by 2010 or earlier.” (emphasis added)
shadowstats.com, Issue Number 39, January 2008
“The mounting evidence is that the Fed-led Cartel is knowingly creating conditions designed to force the U.S. to eventually have to choose between a hyperinflationary great depression and The Cartel’s ominous “End Game” which Deepcaster has described in its January, 2008 Letter.
Deepcaster, February 14, 2008
The Future - - Darkly Liquid Derivatives Destructive Ripple Effects
Indeed, the Markets have already begun to experience, and will continue to experience, what Deepcaster calls The ‘Darkly Liquid (i.e. OTC) Derivatives Destructive Ripple Effect.’
The CDS Market Meltdown catalyzed by Lehman Brothers bankruptcy is only the first shoe to fall.
That is, the $309 Trillion (bis.org, Dec., 2007) Interest Rate Swaps Market has only just begun to melt.
A Systemic Solution
Indeed, Exchange-Traded, Clearinghouse guaranteed, Publicly Marketed, Transparently Visible (as opposed to darkly liquid OTC) derivatives play a very valuable role in our financial and commodities markets!
But if the system is to be saved from collapse, the elimination of some kinds of OTC Derivatives, and the strict and publicly visible regulation of others, is essential.
Also essential to prevent eventual Systemic Collapse, whether through an eventual hyperinflationary depression, or otherwise, is the re-linking of fiat currencies to Gold and Silver, i.e. to Real Money, and not just to some other Fiat Paper.
An Approach to Protecting and Profiting for Investors
The lack of transparency in dark pools and dark books, lack of ability to evaluate counterparty strength, conflicts of interest, and the continuing stagflation and impending credit bubble bursts certainly do not bode well for the future or for portfolios, unless one implements an approach such as the following which addresses these issues.
That is, how does one protect from and profit in spite of these risks? This poses a considerable challenge. A significant focus of Deepcaster’s many Letters and Alerts is aimed at answering these questions. But the following observations may provide some partial answers:
1) Keep a significant portion of your wealth in tangible assets including Precious Monetary Metals (but subject to timing considerations) and Strategic (e.g. Crude Oil) and select Agricultural Commodities that the public needs and regularly uses. Deepcaster has identified certain of these assets and addresses the timing considerations in his recent Letters and Alerts. In general, these Assets should be acquired near the bottoms of Cartel-catalyzed Takedowns, and liquidated near the tops. Remember, “Buy and Hold” rarely works anymore.
Even though The Cartel manipulates the prices of these Tangible Assets down from time to time, in the long run one will be rewarded for owning them, especially if they are in great demand and that demand is relatively inelastic.
2) Attempt to make, although it may be very difficult, an evaluation of counterparty strength. Regarding options, for example, are they clearinghouse guaranteed? And how strong is the clearinghouse?
3) “Go local” in banking, and commercial, and essential goods supply relationships. “Self reliance” and “local reliance” are key goals.
4) Develop an Investing and Trading Regime for certain Key Tangible Assets markets to minimize or avoid the impact of Cartel-initiated takedowns. In this connection, Deepcaster has developed an approach for investing and trading in the Precious Metals Markets described in its article of 3/28/08 “Defeating the Cartel…With Profit”
5) Stay informed about the currently ongoing implementation of “The Cartel’s End Game” as described in Deepcaster’s August 11, 2006 Alert “Massive Financial-Geopolitical Scheme Not Reported by Big Media” and June, 2007 Letter “Profiting From the Push to Denationalize Currencies and Deconstruct Nations” at www.deepcaster.com.
6) Push for transparency.
7) Insist regulators provide oversight.
8) Stay informed. Given the rapidity, magnitude, and increasing significance of “dark liquidity” transactions, failure to stay informed can be lethal. But, since OTC Derivatives transactions are typically “dark,” staying informed is difficult, to say the least. And that is a primary challenge.
Deepcaster
October 24, 2008
DEEPCASTER LLC
www.deepcaster.com
DEEPCASTER FORTRESS ASSETS LETTER
DEEPCASTER HIGH POTENTIAL SPECULATOR
Wealth Preservation Wealth Enhancement
Financial and Geopolitical Intelligence
Gravitas, Pietas, Virtus
-- Posted Friday, 24 October 2008 | Digg This Article | Source: GoldSeek.com
