Derivatives and the Real World Implications

The derivatives market is part of the financial system which operates behind the stock market and shadow banking system. It essentially leverages bets (forward, option or swaps) on the value of commodities, stocks, bonds, interest rates, currencies and anything else they can think of. The value of the market which is hard to nail down but estimates at $700 trillion-$1.4 quadrillion, considering the worlds GDP is about $65 trillion a year, its rather under reported.

Straight from wiki:

“A derivative is a financial instrument which derives its value from the value of underlying entities such as an asset, index, or interest rate. “A derivative is a financial contract whose value is derived from the performance of underlying market factors, such as interest rates, currency exchange rates, and commodity, credit, and equity prices. Derivative transactions include an assortment of financial contracts, including structured debt obligations and deposits, swaps, futures, options, caps, floors, collars, forwards, and various combinations thereof.”

Why is this relevant? Silverdoctors broke the news below and were subsequently hacked. Here’s a slice:

In the introduction, the resolution informs readers that the FDIC and the Bank of England have been working together to formulate the new bail-in model for future bank failures:

The Federal Deposit Insurance Corporation (FDIC) and the Bank of England—together with the Board of Governors of the Federal Reserve System, the Federal Reserve Bank of New York, and the Financial Services Authority— have been working to develop resolution strategies for the failure of globally active, systemically important, financial institutions (SIFIs or G-SIFIs) with significant operations on both sides of the Atlantic.

The goal is to produce resolution strategies that could be implemented for the failure of one or more of the largest financial institutions with extensive activities in our respective jurisdictions. These resolution strategies should maintain systemically important operations and contain threats to financial stability. They should also assign losses to shareholders and unsecured creditors in the group, thereby avoiding the need for a bailout by taxpayers.

The joint US/UK resolution states that depositor haircuts are already legal in the UK thanks to the 2009 UK Banking Act:

In the U.K., the strategy has been developed on the basis of the powers provided by the U.K. Banking Act 2009 and in anticipation of the further powers that will be provided by the European Union Recovery and Resolution Directive and the domestic reforms that implement the recommendations of the U.K. Independent Commission on Banking. Such a strategy would involve the bail-in (write-down or conversion) of creditors at the top of the group in order to restore the whole group to solvency. And that the legal authority has already been given in the US buried in Dodd-Frank Act.

In Laymans terms, if and when a systemic crash happens, customers accounts will be raided!

But today it was revealed that Deutcshe Bank and not JP Morgan, who has the highest derivatives exposure in the world. Located on page 87 of the annual 2012 report it states that its derivatives exposure is €55,605,039,000,000.

Convert that into USD at the current EURUSD exchange rates 29/4/13, it amounts to $72,842,601,090,000…About $2 trillion more than JPMorgan. Through the magical and mythical accounting procedure of netting, this number collapses into €776.7 billion in positive market value exposure (assets), and €756.4 billion in negative market value exposure (liabilities). Rather than magic I’d like to call it what it is, ACCOUNTING FRAUD.

What does that much exposure look like compared to the German GDP?

It’s worrying that big banks can have so much exposure to highly leveraged instruments and when it goes South, Mr Joe Public will have to take the hit, Cyprus was just a try out and it’s coming to a bank near you!

The question is how to protect yourself? Hard assets like land, property and precious metals such as gold or silver would be a good investment and act as a hedge against a bank collapse, as well as inflation. Having a supply of fiat currency would also help protect you if the banks decided to carry out a bail-in.

Testing times are ahead of us.