Should Deutsche Bank Make You Worry About Your Money?
A few days ago I received this email from John, a professional trading friend of mine:
“Be mindful of anything you do that has Deutsche Bank as counterparty — the largest derivative counterparty in the market and not much capital to back it up.”
John is not the only person who sees weakness in Deutsche Bank. Steve Eisman, one of the few people who saw the 2008 Financial Crisis coming is currently short Deutsche Bank.
The problem with derivatives is that any derivative depends upon another asset to give it value. For example, a futures contract is a derivative based upon the value of an underlying asset such as corn, silver or a currency such as the Euro. This dependence upon another asset has breed fragility into the financial system. Because banks, brokers, insurers and other institutions buy and sell derivatives to each other, the value of each institution now depends upon the value of the other institutions it has traded with. This means that if one institution fails, it could spark failure throughout the financial system.
This is exactly what happened during the 2008 Financial Crisis. Lehman Brothers failed and the US Government, followed by governments around the world, had to step in with trillions of dollars to support other institutions that would have likely also collapsed.
Now this may sound regrettable, but perhaps no something to lose sleep about, especially if you do not use Deutsche Bank as a counter party for your investments. However it may be worth spending a moment gaping at the scale of the derivatives market. To do this imagine the size of the imperial ships in Star Wars to get some sense of what we are talking about.
“The visible or measurable size of the derivative market, if you include options, futures, swaps, forex spreads etc., is more than $300 trillion.
But there is an invisible or not easy to measure component, which is probably 3 times larger than 300 trillion.
So those 2 added together, the size of the derivative markets is approaching $1200 trillion.
The total size of the world economy itself is less than $73 trillion.
Actually, no one knows the size of the derivatives market which means the risk it poses to investors cannot be quantified. More importantly, because derivatives have spawned a financial system of mutual dependencies between institutions, there is NO KNOWING which part of the system may be the trigger for general collapse.
Put this another way, you do not have to use Deutsche Bank as a counterparty for your investments for Deutsche Bank to be a risk to your assets. If Deutsche Bank goes down so may the institutions you bought your stocks, mutual funds, tracker funds and property funds from. The assets themselves would also likely lose some or all of their value.
But because the financial system is a system of dependencies, Deutsche Bank should not be your sole concern. Because institutional failure in any part of the system can have consequences throughout the entire system, any part of the system can be the trigger point. There is simply no way of knowing. This is the reason why if you type in “financial crisis” into Google Search you come up with a list of the current most likely scenarios people have identified such as:
So if you have concerns about Deutsche Bank these are really concerns about the financial system as a whole. The key for any prudent investor is to diversify away from this risk. This is likely to mean investing in financial instruments where value is self-generated by investors themselves such as commodities, currencies, real estate and some block chain projects such as Bitcoin and Bitcoin Enhanced.
Because these belief-based instruments do not rely on other underlying assets for their value they do not participate as fully in the house of cards dependencies of the system.
Diversification is the key, but only some financial products enable you to diversify away from the risks posed by the financial system itself.
For a clearer appreciation of which assets to look at this paper outlines the difference between asset-based and belief-based instruments. Belief-based instruments are the ideal because, like the internet, if one instrument fails, the entire system does not go down. That is what diversification was supposed to be all about.
So don’t just worry about Deutsche Bank, do something to diversify away from the risks of a financial system of mutual dependencies.