It is the introduction of synthetic derivatives in place
of actual holdings, and the abuse of counterparty exposure with one's own
organization thereby concentrating risk, that start to make these financial
creatures look even more deadly, and more like control frauds, than one might have previously imagined.
I think that when one of these constructions
fails, as one must almost
surely do, we will then have either an MF Global moment, wherein
one institution goes down and quite
a few customers find that they are holding worthless paper instead of assets, or even worse, an enmeshed counterparty risk triggers another Lehman-like freeze in the credit markets and, as the
dominos fall, a new financial
crisis even worse than the last.
The nastier version would
almost certainly occur if the failure and subsequent disclosure of fraud occurs in some commodity ETF. Why?
In that instance it is more difficult and much more noticeable, although not impossible, for the Congress
and the Fed to throw loads
public money, and subvert justice, to make the problem and full disclosure of fraud to go away.
Stocks and bonds are relatively easy
to counterfeit; physical commodities take a little more energy, boldness, and imagination, the challenge of the shell game rather
than the relatively mechanical process of inflating the world's reserve currency on behalf of financial friends with benefits.
So before you short
stocks in your trading account, with abandon and quite possibly into insolvency, keep in mind that the Fed is perfectly capable of fomenting another bubble to save the status quo, as they did in
2002-2007. To underestimate the corruptibility
of the Fed and the government in partnership with the banks and their corporations can be a costly
XIV on May
So far so vanilla. Now lets look at how, as the ETF market has grown, the clever boys and
girls of finance have found ‘innovative’ ways of pumping those ETFs up a bit, just like they did
Use of Derivatives in ‘Synthetic’
The main innovation in ETFs has been the creation of what are called ‘synthetic’ ETFs which instead
of actually buying or even borrowing a basket of shares, use derivatives to track the value of the underlying
market without the need to match its composition. Instead the Synthetic ETF enters into an asset swap agreement with a counterparty using an over-the-counter (OTC) Derivative. Before explaining what the heck that means let’s
just look at how quickly the Synthetic market has grown.
Synthetic ETFs have grown very rapidly
in Europe and in Asia. In Europe Synthetic ETFs are now 45% of the over all ETF market.
Synthetics doubled their market share between 08 and 09.
The key to Synthetics is
What happens is the ETF Sponsor designs the deal, the AP (Apporved Participant. Usually
one of the big banks or
brokers) buys the basket of assets
to make it, but then swaps that basket with the Counterparty for a different basket of assets in a
derivative swap deal. However
it turns out that rather too
often for comfort, not only will the Sponsor and the
AP be the same bank, but more often than not it will
be the Asset Management branch of the same bank who will
be the Swap Counter-party
as well. It is quite common for the same bank to play all three roles. So a single bank creates the ETF, appoints itself
as AP so it can fund it
and then its Asset Management desk becomes
the derivative counterparty
in order to mutate the whole thing into
a synthetic ETF. Think
about what this does to the risk. What was market
risk, where the risk was spread
out across all the different
shares, is now a single counterparty risk. The bank has effectively put all the ETF’s
risk in one basket – itself.
But even if it is a different bank acting as the derivative counterparty the situation is only very slightly
less incestuous because it is
nearly always the case that the Sponsor, AP and Counter-party
will all be from the same small group of big banks, brokers and Asset
Managers. And it is also a statistical fact that all of them will be
counterparties with each other many,
many times over, via the over $1.2 Quadrillion of other repo, rehypothecation and
derivative deals. This, as the Financial Stability Board’s report on instabilities
in the ETF market rather laconically puts it,
generate new types of risks,
linked to the complexity
and relative opacity of the newest
breed of ETFs. The impact
of such innovations on market
liquidity and on financial
institutions servicing the management of the fund is not yet
fully understood by market participants, especially
during episodes of acute market stress.
Not fully understood?
I think we may not have understood what such entanglements
of reciprocal risk meant before the first period of ‘acute market
stress’, but I think now
it is nutty
to imagine the banks don’t
know how risky such risk incest really
is. The FSB report itself
Since the swap counterparty is typically the bank also acting as ETF provider, investors
may be exposed if the bank defaults. Therefore, problems at those banks
that are most active in
swap-based ETFs may constitute a powerful source of contagion and systemic
forward Deutsche Bank and Soc Gen!
A “powerful source of contagion and systemic risk”. Sounds really good for you and me. So why are the banks doing it
anyway? The official answer
is that using Derivatives means the ETF can track the value of the market
more closely. Though few
have complained that Vanilla ETFs don’t track closely enough. And as the BIS report points
…the lower tracking
error risk comes at the cost of increased counterparty risk to the swap
But this doesn’t
answer why a bank would enter into a swap with itself as the counterparty. The
whole idea of counterparties, once upon a
time, was to hedge some of the risk in the
original deal by passing it off to someone else. Using yourself as counterparty keeps the risk in-house. So once again why?
The answer is, according to the BIS report on ETFs,
structure exploits synergies between banks’ collateral
management practices and the funding of their warehoused securities. (P.5)
‘Synergies’ sounds like it should
be good. Sadly it may not be.
As the BIS goes on to explain,
…synergies arise from the market-making activities of investment banking, which usually require maintaining a large inventory of stocks and bonds …. When these stocks and bonds are
less liquid, they will have to be funded either
in the unsecured markets
or in repo markets with deep haircuts. (P.8)
In essence it costs
the banks money to have illiquid
assets on their books.
The repo markets won’t
accept them as collateral unless they come with a deep haircut. So the banks can do little with them
except sit on them. Basically it costs the bank to have the illiquid, hard
to sell or Repo, stocks on its
books. But.. .if they happen
to have created a handy synthetic ETF, then everything changes because,
For example, there
could be incentives to post illiquid securities as collateral assets [in the ETF Swap]…. By posting
them as collateral assets to the ETF sponsor in a swap transaction, the investment bank division can effectively fund these assets
at zero cost….
it? Assets they can’t repo without hefty haircuts can be posted as collateral to their own ETF with the approval of the ETF Sponsor of course – who will just
happen to be… the same bank – without those pesky, hurtful haircuts. In fact,
The cost savings
accruing to the investment
banking activities can be directly
linked to the quality of
the collateral assets transferred to the ETF sponsor.
The worse they
are, the more illiquid, the more the bank saves/makes
by choosing to put them
in an ETF rather than having them loiter
on its books.
…the synthetic ETF creation process may be driven
by the possibility for the bank
to raise funding against an illiquid portfolio that cannot otherwise
be financed in the repo market. (FSB report P.4)
This is surely
financial innovation at its shining best.
Now of course the banks will say they
would never consider slipping some old tat into their ETF under cover of opacity. Except that they did,
every one of them, do exactly that when they systematically
and grossly lied about every
single aspect of hundreds of billions worth of shabby mortgages which they intentionally stuffed into CDOs in order to shaft and rob those they sold them
to. This is a matter of
Read the rest here.
See also Part 1 - ETFs and Derivatives Will Be
the Trigger Event For the Next Financial Crisis
"The World Is Deaf" (ou
peut-être, 'fou furieux à nouveau' - Jess)