A World Powered by Debt: Why Central Banking Sucks

WHAT

Here is an article written by my friend & fellow crypto zealot Tim Goggin (co-founder of DNotes). I wanted to share this piece because it does a good job of illustrating the ridiculousness surrounding digital currency skepticism. Much of the financial industry is wary of this alternative to traditional currency, all-the-while, our entire system of banking is one massive, vulnerable stockpile of leverage. In other words: Skeptics of digital currency appear to have no problem putting their faith in the irresponsible establishment, yet they shy away from what could turn out to be the safest & most secure form of exchange. I have separated the article into parts for organizational purposes, but all of the content is in its original state. Some of the language used will be a bit difficult to understand for novice investors/ economists, but this material is definitely worth a read. With the aid of thinkers like Tim & communities such as Steemit, we the people can begin to take back control. Central banking and big government will be the end of our ability to pursue happiness & financial prosperity if we do not keep them in check.

Zero Interest-Rate Policy

How ZIRP ends with the biggest bang of all-  Whenever you hear people talk about crypto-currencies, at least when I do, the one thing they bring up is the unsustainability of fiat currency, how it's all going to collapse eventually and that one day it will all end. But how exactly does this happen? What brings it to the forefront? And exactly how will we know when this happens? These are questions people either avoid or misdirect from, because the answer is fairly complex to understand. But simple once understood. Just upfront, this will be a financial article, I will try and simplify wherever I can for you guys.   

With the failure of Spanish bank Banco Popular today, and everyone wondering how Santander can do due diligence on over $150B of assets in under 24 hours. I thought I'd highlight the real elephant in the room which is according to the latest BIS figures the global derivative market now at an eye watering $482 Trillion notional http://www.bis.org/statistics/d5_1.pdf value according to BIS tracking (which is about 95~% of global derivatives they monitor). And with the top 4 US banks holding $147 Trillion notional according to the OCC <http://prntscr.com/fhklin>. With government debts now totalling over an equally eye watering $58 Trillion worldwide http://www.economist.com/content/global_debt_clock. With almost every central bank having interest rates at zero, close to zero, or negative. One comes to ask, how is this even possible, let alone how does it end.
 

One of, if not the biggest issue with ZIRP (Zero interest rate policy) for the banking sector is the fact that it has compressed the margins in traditional banking operations to the point where they are unprofitable in most cases. Where 1-2 point spreads are the most they can hope for, this leads to banks having to get creative in order to maintain both profits for shareholders and simple operational cash flow. This creativity leads to the banking sector simply over leveraging  itself to the point where it can maintain itself with the tiny traditional operating margins that they have. Thus spawning the modern shadow banking system and the behemoth that is the financial world today, in a chase for returns leveraging themselves far beyond what has ever traditionally happened within banking.   

When presented with such huge numbers in derivative exposure, the first statement made by almost every bank economist is that gross is not net, this is total notional value, not net value. That net value is much much lower. This is absolutely true, all the way up until it isn't. Almost every bank spokesman will tell you something along the lines of “we have bilateral netting which eliminates net exposure almost entirely”. Which while seemingly true, the question in any trade is simple. Who's on the other side?  

The Role Central Banking Plays in Financial Crashes (Such as '08)

The real issue with this entire system is the underlying understanding of bilateral netting thinking that during collapse or failure, all contracts will be honored by the issuer. However, as the financial world found out almost 10 years ago with both the fallout of Leheman and AIG, this is almost never the case. Luckily in finance we have an attention span of about a week, so almost 10 years is like it never happened at all. In AIG's case specifically the insurance company was on the verge of making literally trillions worth of contracts worthless if it was to implode. Hence of course taxpayers had to bail it out, because we couldn't have bankers lose money.   

The next statement people make is even in failure, under bankruptcy they get senior creditor status so they will get made whole for the most part anyway. Well even for those who aren't well versed in bankruptcy, this is a notion that is nowhere near likely in practical reality. Firstly I don’t think they would even get senior creditor status, although it depends on the specific individual contract. This however in bankruptcy may get 5-10c on the dollar if they are lucky. While one can hedge this downside with protection on such event failures, the question is who do you purchase it from, and who pays out in collapse scenario?
 

This of course leads to the logical question of how do banks hedge the downside risk of such events? Well they purchase CDS contracts on the default event of the issuer themselves, thus putting even higher pressure on the strongest aspect of the link. This leads to an over-leveraging of the system with the goal being to mitigate risk individually, drastically ramps risk up for the system itself. Because if everyone is purchasing downside risk from each other, when it all goes bad, who ends up paying out?   

Think of it like a mexican standoff. 3 people in a room, each owes the other 1 million dollars, well the entire room has 3 million dollars in debt. Everyone's a millionaire, even if nobody has a penny (which is how the book value of these look, that's why Deutsche Bank with $40T notional derivatives can almost implode with such razor thin operating capital). Well what happens if everyone owes each other 10 Trillion? Fine, what happens however if one can no longer pay to roll over the contracts, as we found with Leheman. The question isn't if this happens however, the question is when. Because of the unsustainability of fiat currency, this outcome is a guaranteed certainty. What happens though when only a handful of institutions are the main underwriters of these contracts cannot be fulfilled, not because they haven't planned properly, but because the counter-party can no longer pay. And thus is the snag with the entire system of musical chairs.  

This Trend of Massive Leverage Is Far From Resolved 

 Now the deleveraging of this has been going on slowly for years now, we've gone from almost $700T to just under $500T. However with bank failures like Banco Popular, Greece and the rest of the PIGS that are like a terminal illness that never goes away, and the ugliest wart of them all being Deutchebank exposed to the world, collateral issues, Basel requirements. This issue isn't going anywhere. And with bank profits at stake the risk of the biggest margin call the world has ever seen is possible. And it won't be from any broker, it will simply be a fission reaction from the financial system itself.  

No matter what any sell side analyst says when the bilateral netting chain is broken, because these events can and will happen. These contracts will simply no longer generate book value cash flow streams for the counterparties. This will go until the very end, and then the entire credit pyramid collapses on itself and both the banking and shadow banking system will be forced to delever itself. Either by bankruptcy or by inflation. But this cannot be wriggled out from, the numbers are too big, and this time taxpayers can't foot the bill.  

However as everyone says not to worry about the gross number and only worry about net until everyone realizes that gross becomes net once the thin thread of bilateral netting is broken. And it only takes one, simply because of how leveraged the entire system is now because of ZIRP and the chasing of yield and returns for banks. Because the assumption that there is no counterparty risk is what keeps the entire thing afloat, and this can only go on as long as people believe either taxpayer backed banks cannot fail and thus will always be solvent which will mean the taxpayers will pay via inflation. Or the banks lose. Something we haven't contemplated or seen on any type of mass scale in generations in the west.  

In Conclusion...

The real question is how long can this go? Well I think that as it gets worse, market value of the total derivative market will decline and net value will decrease, and an increase in notional value will be the canary in the coal mine. The reason for this is because this is what they will do to ensure banks maintain profitability structures in a ZIRP environment. Because banks can no longer operate as functional banks, these instruments, particularly currency swaps and are one of the most efficient way for them to leverage cash flow to maintain bank profits. And since taxpayers are the underwriters, nobody cares about either counter-party risk, macro risk, or any type of long term sustainability. Because at this casino if you win you win and if you lose, you get re-reimbursed.  

And that’s how literally hundreds of trillions of dollars disappears. Like a magic trick, just less fun and all at once.