Counterparty Risks and the Gathering Storm: Inadequate Solutions and Absurd Voices

by John E. Charalambakis In a recent commentary we pointed out […]

by John E. Charalambakis

In a recent commentary we pointed out that, one of the largest clearing houses asked for a $50 billion capital contribution from member institutions, (see more ). We have also been pointing out that collateral deficits undermine the stability of the financial system, especially when the sword of derivatives is hanging over the head of financial markets.

A couple of days ago, Bloomberg reported that global regulators are struggling to find a solution to the enigma of what may happen if more than two defaults happen simultaneously and the clearing houses do not have enough capital to absorb the consequences (bloombergview ).

As a result of the lessons we learned from the financial crisis, most US derivatives nowadays go through clearing houses such as DTCC. The objective is to contain systemic risk. However, as the Bloomberg article points out: “clearing houses present a risk of their own. If a crisis triggers defaults that overwhelm the posted collateral, they have little capital of their own to absorb losses. Beyond that, they’d rely on tapping a pre-paid guaranty fund and then calling in cash from the financial institutions that are their main customers — demands that in a crisis could cause distress to spread.”

We are of the opinion that recent market tremors have mostly to do with derivatives, the collateral deficits and the possible tremors in clearing houses. Policy makers failed to contain the risks of these “weapons of mass destruction” – as Warren Buffett calls them – when they were ascending in the late 1990s and in the 2000s, and now we use absurd notions of secular stagnation theories or “helicopter money” to save the system from the gathering storm.

The central bank of central banks a.k.a. BIS (Bank of International Settlements) has been warning about the derivatives risk, and lately has been warning that central banks may be running out of cards and options, implying that negative rates cannot revitalize growth and economies. Capital flight from equities to the safety of developed countries’ bonds is indicative of the uneasiness of investors, while the widening credit spreads brought to mind recessionary scenarios and bear markets. Sentimental and bottom-fishing strategies are helping to wipe out the majority of the losses since the beginning of the year, as we expected. This may continue but fundamentally, nothing has changed. The inability of policymakers to address the root cause of the tremors, has been telling us that caution is needed and capital deployment requires hedging and anchoring.

As Larry Goodman’s post last Tuesday demonstrated, market finance in the US “is now about 30% below where it should be to foster growth above 2.5% on a sustained basis. „We believe that market distortions introduced by the hyperactivity of central banks is one of the main causes for that. The market turbulence is indicative of market liquidity issues, and the latter when combined with inadequate collateral and insufficient capital cushions, becomes the gathering storm’s element that will reverberate the loudest when the next crisis hits.

As for the suggestion of Wolfgang Munchau in the Financial Times last Monday that the ECB needs to print and distribute €10,000 to each EU citizen, our only comment is: Why not €50,000, or even better why doesn’t the ECB force retirement for everyone over the age of 50 at a rate of €3,000 a month? Most certainly, unemployment will decrease and the triumph of central banking will be complete.


BlackSummit Financial Group


The views expressed on austriancenter.com are not necessarily those of the Austrian Economics Center.

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