RGEmonitor reports that collateral use increases by 86% to $4 trillion in OTC derivative market.
(emphasis mine) [my comment]
Collateral Use Increases By 86% to $4 Trillion
Apr 27, 2009
In a release last week, the International Swaps and Derivatives Association has determined that collateral in circulation has essentially doubled from its 2008 estimate of $2.1 Trillion to $4 Trillion [banks are using this cash to fund their operations]. Not surprisingly most of this collateral is in cash.
Cash continues to grow in importance among most firms, and now stands at over 84 percent of collateral received and 83 percent of collateral delivered.
Another interesting tangent is where all this money is invested, with Treasuries (especially one month and other near maturities) likely being an easy conclusion [Banks can use these treasuries as collateral for repo loans, thereby funding their holdings of toxic debt]. Any endogenous risk events will likely have a shakeout not only in the derivative collateral market but also in their downstream investment, and could potentially be yet another shock to treasury holdings, especially if a wholesale unwind forces the accelerated sale of Treasuries by collateral counterparties.
KBC Merchant Banking reports that past trends in the OTC derivative market.
In the past, collateralization was only used for 'on-exchange derivatives'. The practice of initial- and variation margining has been used since the early 1980s, when several futures and options exchanges were founded in the US (e.g. CBOT) and in Europe.
Increased attention to risk management, reinforced by a series of market disturbances in the 1990s, has contributed to the growth of the collateralization of financial transactions over and beyond the regulated futures and options business. The concept of collateralized trading in the OTC sphere grew out of repo activities and the securities-lending business, both of which are effectively collateralized markets [Repo activities, securities lending, and derivative collateral were three of the financial innovations that enabled the massive credit bubble we have come to know and hate]. As financial institutions and hedge funds expanded their operations [into subprime mortgages] and accordingly required additional credit lines, the collateralization of OTC derivatives continued to increase in importance [banks used (and are still using) the collateral from OTC derivatives to fund their "expanding operations"]. Today, collateralization is becoming standard market practice in the US and Europe, with Asia following rapidly on the heels of the West. Initially, only banks and hedge funds set up collateral agreements with each other. However, collateralized trading has since spread quickly to other market participants such as companies.
The growth of the collateral market is clearly illustrated by the results of the 2006 ISDA Margin Survey, which is conducted every year. Banks and brokers remain the largest category participating in the survey, followed by institutional investors and hedge funds. The constantly rising percentage of participating corporate counterparties is a strong indication that collateralization is becoming standard practice amongst all market participants.
Based on the 2006 Survey results, ISDA estimates the gross amount of collateral in use to be $1.329 trillion as of the end of 2005. This amount represents a growth rate of 10 percent over the previous year. [Looking at this data, remember that this collateral/cash was being plowed into mortgage CDOs. This is where the demand for subprime mortgages came from]
Reuters reports that banks see risk in central clearing of derivatives.
Central clearing of derivatives seen adding risk
Tue Jun 9, 2009 4:31pm EDT
NEW YORK, June 9 (Reuters) - Proposals to require that all contracts in the $450 trillion [OTC] derivatives market be centrally cleared could tie up valuable capital and constrain the liquidity of
companies [banks] that use the contracts to hedge [fund] their businesses, derivatives users and dealers warned on Tuesday.
The use of central clearinghouses is viewed as key to removing systemic risks posed by the contracts, should the failure of a large dealer spark a chain of losses globally. The issue arose after the collapse last year of Lehman Brothers and insurer American International Group.
[Banks are TERRIFIED by proposals to have all contracts in the $450 trillion OTC derivatives market centrally cleared. One of the roles of central clearinghouses is to hold on to collateral from both parties. If OTC derivative are centrally cleared, banks would lose access to the cheap funding provided by the 4 trillion in cash collateral they currently control. They don't have anything that anything which could replace it.]
Intent reports about The Invisible One Quadrillion Dollar Equation.
Financial Chaos: The Invisible One Quadrillion Dollar Equation
Posted Sun, 09/28/2008 - 21:00
According to various distinguished sources including the Bank for International Settlements (BIS) in Basel, Switzerland -- the central bankers' bank -- the amount of outstanding derivatives worldwide as of December 2007 crossed $1.144 Quadrillion, ie, $1,144 Trillion.
The main categories of the USD 1.144 Quadrillion derivatives market were the following:
1. Listed credit derivatives stood at USD 548 trillion; [I haven't talked about listed derivatives much, mainly because I didn't realize their size. Collateral requirements are much stricter in listed/regulated markets, which means the collateral behind these 548 trillion listed derivatives is probably around $10 trillion (my guesstimate)]
2. The Over-The-Counter (OTC) derivatives stood in notional or face value at USD 596 trillion and included:
a. Interest Rate Derivatives at about USD 393+ trillion;
b. Credit Default Swaps at about USD 58+ trillion;
c. Foreign Exchange Derivatives at about USD 56+ trillion;
d. Commodity Derivatives at about USD 9 trillion;
e. Equity Linked Derivatives at about USD 8.5 trillion; and
f. Unallocated Derivatives at about USD 71+ trillion.
Quadrillion? That is a number only super computing engineers and astronomers used to use, not economists and bankers! For example, the North star is "just" a couple of quadrillion miles away, ie, a few thousand trillion miles.
Counting one dollar per second, it would take 32 million years to count to one Quadrillion. The numbers we are dealing with are absolutely astronomical, and from the realms of super computing we have stepped into global economics.
My opinion about derivatives is best summarized by Rense.com article titled the $1.5 quadrillion derivatives bubble.
... Humanity is in agony, and we must act against derivatives now. Going forward, we must ban the paper pyramids of derivatives in the same way that the Public Utility Holding Company Act of 1935 banned the pyramiding of holding companies.
Derivatives were illegal in the United States between 1936 and 1983. In 1933, an attempt was made to corner the wheat futures market using options, and the resulting outcry led to a 1936 federal law banning such options on farm commodity markets. This ban was repealed by the Futures Trading Act of 1982, signed by President Reagan in January 1983. During the G.H.W. Bush administration, Wendy Gramm of the Commodity Future Trading Commission went further, promising a "safe harbor" for derivatives. Despite the key role of derivatives in the Orange County disaster during the Clinton years, a valiant attempt by Brooksley Born of the CFTC to make derivatives reportable and subject to regulation was defeated by a united front of Robert Rubin, Larry Summers (today running US economic policy), and Greenspan. Despite the central role of $1 trillion of derivatives in the Long Term Capital Management debacle of 1998, Phil Gramm's Commodity Futures Modernization Act of 2000 guaranteed that derivatives, notably credit default swaps, would remain totally unregulated. These pro-derivatives forces must bear responsibility for the current depression, and those still in power must be ousted
The derivatives are the black holes of financial engineering, and can easily consume all the physical wealth and all the money in the world, and still be bankrupt. Gordon Brown's demand of $500 billion for the IMF is enough to bankrupt several nations, but pitifully inadequate to deal with the derivatives. They can only be dealt with by re-regulation -- a quick freeze, leading to extinction and permanent illegality. We reject Brown's IMF world derivatives dictatorship.
Derivatives pose the question of fictitious capital -- financial instruments created outside of the realm of production, and which destroy production. In 1931-2, fictitious capital appeared as tens of billions of dollars of reparations imposed on Germany, plus the war debts owed by Britain and France to the United States. These debts strangled world production and world trade. Bankers and statesmen tried desperately to maintain these debt structures. But US President Herbert Hoover proposed the Hoover Moratorium of 1931-1932, a temporary freeze on all these payments. The Lausanne Conference of June 1932 was the last chance to wipe out the debt permanently. But the Lausanne Conference failed to act decisively, and passed the buck. By the end of 1932, there was near-universal default on reparations and war debts anyway [This is the fate of the derivative market: near-universal default]. And by January 1933, Hitler had seized power. We urge the London G-20 to defend world civilization against derivatives. It is time to lift the crushing weight of derivatives from the backs of humanity before the world economy and the major nations collapse into irreversible chaos and war, as seen during the 1930s.
My reaction: Derivatives bear great responsibility for the current depression.
1) The collateral in circulation in the OTC derivatives market has doubled from $2.1 Trillion in 2008 to $4 Trillion in 2009.
2) Cash continues to grow in importance (84 percent of collateral received/delivered).
3) This $4 Trillion (mostly cash) collateral is invested in treasuries, especially one month and other near maturities
4) Banks can use these treasuries as collateral for repo loans, thereby funding their holdings of toxic debt.
5) Any shakeout in the derivative collateral market would create yet another shock to treasury markets by forcing the accelerated sale of Treasuries by collateral counterparties.
6) The concept of collateralized trading in the OTC sphere grew out of repo activities and the securities-lending business. Repo activities, securities lending, and derivative collateral were three of the financial innovations that enabled the massive credit bubble we have come to know and hate.
7) Banks used (and are still using) the collateral from OTC derivatives to fund their expanding operations (into subprime mortgages).
8) Proposals to require that all contracts in the $450 trillion OTC derivatives market centrally cleared are terrifying banks.
9) The use of central clearinghouses is viewed as key to removing systemic risks posed by the contracts, should the failure of a large dealer spark a chain of losses globally
10) If OTC derivative are centrally cleared, banks would lose access to the cheap funding provided by the 4 trillion in cash collateral they currently control.
11) The gross amount of collateral in use in OTC markets has been growing at double digits rates in recent years (ie: 10 percent in 2005)
12) The growing pile of collateral/cash was being plowed into 'AAA' (toxic) debt and explains much of the demand for subprime mortgages.
13) According to various distinguished sources, the amount of outstanding derivatives worldwide as of December 2007 crossed $1.144 Quadrillion ($1,144 Trillion).
14) The $1.144 Quadrillion derivatives market is made up of listed credit derivatives totaling $548 trillion and OTC derivatives totaling $596 trillion
15) Derivatives were illegal in the United States between 1936 and 1983.
16) The fate of the derivative market is near-universal default.
Conclusions about derivative markets:
1) There is probably $14 Trillion collateral behind listed/OTC derivative markets ($10 Trillion from listed derivatives and $4 Trillion from OTC derivatives).
2) This $14 Trillion collateral is invested in dollar-denominated debt. As the dollar collapses (as a result of fed's money printing), interest rates will skyrocket and this collateral will lose all value. Investors trying to collect on profitable bets (ie: call options on gold miners) will find their derivative contracts backed by insolvent counterparties and worthless debt.
3) Most of the $2 Trillion jump in OTC derivative collateral which occurred last year probably happened after the Lehman bankruptcy, and it explains the big rally in treasuries.
4) (Insolvent) banks relying on collateral from OTC derivatives for funding. If OTC contracts are centrally cleared as is being proposed, it will create another liquidity crisis, like after Lehman.
5) Derivatives are fictitious capital. No matter what type of derivative contract an investor buys, his money flows into the US credit market. As a result, while derivatives give investors the illusion of worth, they are in fact backed by the largest credit bubble in the history of mankind. Their real worth is zero (hence they are fictitious capital).
6) Anyone buying options, forwards, swaps, and other derivatives contracts is making a long term bet on the solvency of the United States and the continued worth of the dollar. This is a disastrous bet.
7) Derivatives were illegal once, and (after the near-universal default on outstanding contracts) they should be made illegal again.
Sell any derivative contracts you own, and use the proceeds to:
A) Buy equities via non-margin brokerage accounts (at an institution you trust).
B) Buy non-dollar, non-pound, non-yen debt (of a solvent institution)
C) Buy physical assets/commodities (especially gold and silver)