The Next Shoe

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ISRS Senior Research Fellow, Chris Cook in this article addresses the susceptibility of financial markets to a price discontinuity, and why the current regulatory policy might almost have been designed to make a bad situation worse.

The Next Shoe

In the summer of 2005 I was invited to speak – in relation to energy markets – at a conference in Lausanne convened by the Geneva Centre for Security Policy on the subject of ‘Economic Terrorism’.  Essentially this conference concerned the resilience of financial rather than physical infrastructure to attack by terrorists using economic rather than physical means.

My message was that the existing market architecture concentrated risk in centralised organisations such as banks and clearing houses to an extent that was not appreciated. I made the wry observation that the only difference between a hedge fund and an economic terrorist was their motive.

In October 2008 the first shoe dropped.  Following the collapse of Lehman Brothers, which I regard as a milestone in the evolution of markets, we saw the financial system freeze up almost entirely. In fact, in the UK we came two hours away from the ATMs being switched off, and a day or so from what has been described as ‘shopping with violence’.

In the aftermath of this seminal event we saw dollar interest rates crash to zero, and the Federal Reserve Bank embarking on the massive money creation and injection into the financial system known as Quantitative Easing (QE). The reaction of investors to these events was to pour their dollars into the new breed of Exchange Traded Funds (ETFs) which invested in non-income producing assets such as gold, metals and commodities as a ‘hedge against inflation’, to use the marketing phrase adopted by the investment banks who manufactured these funds

In a cosmic irony, this inflation hedging passive investment had the effect of financialising the markets in which it became dominant; creating correlated bubbles; and causing the very inflation these risk averse (the complete opposite of risk taking speculators) and passive investors sought to avoid.

Regulatory Response

As a response to the Lehman meltdown the regulators acted to address the revealed systemic financial instability.

They decided that the best response was to bring the opaque bilateral ‘over the counter’ market in the derivatives, whose leverage was a major factor in the problem, into a central clearing house.

The good news is that this does indeed provide transparency to regulators: the bad news is that it concentrates market risk in a single point of failure which is susceptible to discontinuities in price following ‘Black Swan’ events.

Market Discontinuities

The best known example of a market discontinuity was the 1985 Tin Crisis which occurred when a  cartel of tin producers which had been supporting the tin price using London Metal Exchange forward/futures contracts ran out of money. The price literally collapsed overnight from $8,000 per tonne to $4,000 per tonne; the exchange imposed a settlement price at $6,000 per tonne, and litigation by those adversely affected rumbled on for many years.

Such a discontinuity is quite possible today, particularly in the market in crude oil, which has been the subject for years of a macro manipulation by producers who obtain cheap finance from the ‘inflation hedger’ funds mentioned above.  Essentially the producers lend oil to passive investors – using derivatives or the prepay contracts rediscovered by Enron – while the passive investors lend dollars to producers.

The prepay mechanism is now in routine use. For instance, Russia’s Rosneft is unwilling to sell ownership (equity) while banks are unwilling to lend to Rosneft (debt).  So we now see, as a third way between equity and debt, the major trading houses Glencore, Trafigura and Vitol entering into crude oil prepay contracts with Rosneft, where they buy crude oil at a discounted price for cash now and delivery later.

These trading houses borrow the necessary dollars from banks and then offload their market price risk onto the relevant clearing houses.  In my view, the transparent and direct use of prepay instruments for financing (Peer to Peer credit) and funding (Peer to Asset credit) will lead to a resilient networked financial system.

But the current opaque use of prepay instruments by intermediaries – notoriously pioneered by Enron – is an accident waiting to happen, exacerbated by the wave of demutualisation of exchanges and the fragmentation of clearing houses into proprietary siloes.

This is because Risk is akin to Energy: it cannot be destroyed: it can merely be moved around and change state. The market risk formerly taken by banks has now been outsourced to Clearing Houses which are not in my view capitalised for the true risks they run.

Many of those investors who were worried enough about inflation to hedge it using ETFs are now selling their units and buying into asset classes like stocks and property which offer at least some yield.

As this fund money drains out, the financialisation comes to an end and commodity price bubbles will deflate: the only question is the rate at which this fall in price will occur, and I believe that there is a significant possibility that a market price discontinuity like that in the 1985 tin market could well be the next shoe to drop.

Not only are the regulators failing to address this systemic risk: the centralising policies they have been developing might almost be designed to create it.