The Looming Financial Derivative Crisis

• The Looming Financial Derivative Crisis
  by Alasdair Macleod, https://www.goldmoney.com/
  The powerful forces of bank credit contraction are at the heart of a rapidly evolving financial crisis in global derivatives, whose gross value is over $600 trillion; an unimaginable sum. Central banks are on course to destroy their currencies through unlimited monetary expansion, lethal for bullion banks with fractionally reserved unallocated gold accounts, while being dramatically short of Comex futures.
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  This article explains the dynamics behind the current crisis in precious metal derivatives, and why it is the observable part of a wider derivative catastrophe that is caught in the tension between contracting bank credit and infinite monetary inflation.
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  Introduction
  One of the scares at the time of the Lehman crisis was that insolvent counterparties risked collapsing the whole over-the-counter derivative complex. It was for this reason that AIG, a non-bank originator of many derivative contracts, had to be bailed out by the Fed. By a mixture of good judgement and fortune a derivative crisis was averted, and by consolidating some of the outstanding positions, the gross value of OTC derivatives was subsequently reduced.
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  According to the Bank for International Settlements, in mid-June last year all global OTC contracts outstanding were still unimaginably large at $640 trillion, a massive sum in anyone’s book. It is unlikely to have changed much by today. But in bank balance sheets only a net figure is usually shown, and you have to search the notes to financial statements to find evidence of gross exposure. It is the gross that matters, because each contract bears counterparty risk, sometimes involving several parties, and derivative payment failures could make the payment failures now evident in disrupted industrial supply chains look like small beer.
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  Deutsche Bank’s 2019 balance sheet gives us an excellent example of how they are accounted for in commercial banks. It conceals derivative exposure under the headings “Trading assets” and “Trading liabilities” on the balance sheet. You have to go into the notes to discover that under Trading assets, derivative financial instruments total €80.848bn, and under Trading liabilities, derivative financial instruments total €81.910bn, a difference of €1.062bn This is relatively trivial for a bank with a balance sheet of €777bn.
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  But wait, there is another table that breaks derivative exposure down even further into categories, and it turns out the earlier figures are consolidated totals. The true total of OTC derivatives and exchange traded derivatives to which the bank is exposed is €37.121 trillion. That is nearly thirty-five thousand times the €1.062bn netted difference in the balance sheet. And when you bear in mind that valuing OTC derivatives is somewhat subjective, or as the cynics say, mark to myth, it invalidates the valuation exercise.
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  Clearly, by taking the mildest of a positive approach to derivatives held as assets, and a slightly more conservative approach to valuing derivatives on the liabilities side, that 35,000:1 leverage at the balance sheet level can make an enormous difference.
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