The Domino Falls — What Happens During Systemic Financial Meltdown (Draft)

By Simon Paige on The Capital

Simon Paige
Jan 7 · 11 min read

Why do the financial markets appear so fragile? Why is there a risk of meltdown? What would such an event look like? By exploring possible scenarios I hope to bring home why systemic financial meltdown is perhaps the greatest risk of our times.

The purpose of this article is to paint a graphic picture of what financial meltdown looks like. I value your input. Please email me your comments and contributions so that our knowledge of how market collapse is likely to unfold becomes clearer. Share with me what you believe are its consequences for investors, pensioners, and society. All contributions will be acknowledged in the final draft. I can be reached at branton@kenton-dau.com .

There is a saying, no points for predicting the Flood, only for building an Ark. This article is only about the Flood. For information about my efforts in Ark building please visit: https://www.kenton-dau.com/self-managed-investments-smis.html

“Amidst the economic chaos, millions find their pensions sharply reduced or vanished altogether. What once looked like a secure income stream for retirement has all but disappeared. ‘How did we arrive at this situation?’ They ask.”

The Inevitability Financial Collapse

Systemic risk is the risk of the financial system collapsing as the result of the failure of its leading institutions. Today these banks, insurers, clearinghouses, brokers, and exchanges are embedded in a web of financial dependencies which means that the failure of one can create a cascade of insolvencies that ripples through the system. We outline here how such an event could take place and what such a collapse could look like.

Ironically these dependencies are the result of the desire to spread the risk of individual loans, underwriting, and other obligations through the use of derivative products such as Credit Default Swaps. From the mid-1990s derivatives have been the fastest-growing asset class. They are now larger than all other asset classes put together including equities, currency, property, and bonds.[1]

Systemic risk is, therefore, a structural issue describing the way the financial system is now built. The paradox of our times is that the desire to mitigate risk has led to the creation of the greatest risk of all — total meltdown.[2]

Because systemic risk is a design issue the probability of another event is near certain. Every day servers in Google’s server farms fail. Failure is inevitable. The difference between the financial system and Google’s server configuration is that the financial system is akin to Google running all its services on just one server — a server that inevitably will one day fail. Google would never operate in this way because the risk is too great.

Contagion

The trigger for the systemic collapse can come from any part of the system at any time. For example, it could be the collapse of a regional Italian bank or a liquidity crisis in volatility markets

The collapse of, say, bank A removes the counterparty to the derivative contracts other institutions have traded with the bank. As a result banks B, C and D find themselves technically insolvent as the contracts they hold with Bank A now have little or no value.

Banks E, F, G, and H become aware of the solvency issues at banks B, C, and D and see them as risky trading partners. As a result, they call in the loans and other obligations with banks B, C, and D and stop trading with them. This only deepens the crisis for banks B, C, and D who suddenly find greater demands upon their fast-dwindling assets at exactly the time when they cannot borrow to generate the required liquidity. Like bank A, banks B, C and D also fail.

Their failure repeats the process for banks E, F, G, and H who now find themselves insolvent due to their derivative trading with banks A, B, C, and D. Other banks I, J, K, L, M now do exactly the same to them by calling in obligations and cutting off credit as they have so recently done to B, C and D. The contagion continues to spread across all institutions linked to each other through derivative obligations until most are insolvent and access to liquidity has disappeared.

Bailout

In order to prevent meltdown governments step in with massive bailouts for the affected firms. In effect, governments promise to cover a firm’s obligations to other firms in order to prevent further collapse. The move helps to restore confidence in the firms and the system as a whole. Investor confidence is restored as solvency issues are resolved. Share prices that have plummeted during the crisis rise.

At the same time, central banks increase money supply through the purchase of the debt obligations of affected firms. This new liquidity helps to encourage the resumption of lending between firms.

Bailouts and new liquidity prevent a further meltdown. The risk of systemic collapse is averted.

This is what happened in 2008. But will governments and their central banks be willing or able to play the same role again? Here are several possible scenarios.

Scenario 1: The Crisis is still with us

Since 2008 the Federal Reserve has injected $3 trillion into the economy but remains unable to cease the constant expansion of base money for fear of the consequences. This begs the question as to whether the 2008 systemic crisis was averted or simply delayed. The historical evidence for the view that the crisis has simply been delayed is strong: centuries of experiment with fiat currencies have ended in failure if there is not a return to hard money. [3]

While systemic risk is the result of financial dependencies between large institutions, the possibility of bailout depends upon fiat currencies. In a hard money environment, central banks would have no discretion to fund government bailouts or to expand money supply. Base money supply is expanded or contracted only to maintain the currency’s value.

Scenario 2: Chinese Expansion

During the Cold War official US policy in the event of a nuclear war was an all-out counter-attack on the Soviet Union. Termed Mutually Assured Destruction (MAD) the theory was that the threat of total annihilation would deter any aggressor. However, both the Soviet Union and the United States also had plans about how they could survive an all-out nuclear attack.

Applying the military logic of MAD to economic competition between countries could see the US government technically bankrupt and unable to offer bailouts during the next systemic event. For example, China may believe financial meltdown, while devastating in the short term, could lead to their eventual dominance globally. By being better prepared and less exposed to the effects of collapse through greater economic self-reliance China’s leaders could see the next systemic event as an opportunity.

As the largest holder of US government debt during the next systemic crisis, China sells its US bonds on the open market. Confidence in the bonds immediately drops making it impossible for the US government to issue more debt, at least to overseas buyers.

Only the Federal Reserve remains to fund the bailouts through the purchase of new US debt. However, loss of confidence in US debt also leads to a fall in demand for US dollars. As demand for dollars drops, inflation begins. This puts the Federal Reserve in a no-win situation: to fund the bailouts it needs to print more money through the purchase of US government debt but to combat inflation is needed itself to sell debt to contract money supply and support the dollar’s value.

If the Fed opts to sell US debt it finds no buyers, as, following China’s lead, US treasuries are no longer considered risk-free. If it seeks to expand money supply, it fuels inflation.

Assuming the Fed purchases government debt to fund the bailouts the resulting increase in inflation further reduces demand for the US dollar as confidence in its stability evaporates. Investors dump the dollar and dollar-denominated investments in the search for safe havens. The US government’s efforts to contain the financial crisis are constrained by lack of buyers for its debt and a rapidly inflating currency. As a result, financial contagion continues to spread.

Scenario 3: US Consolidation

In this scenario, sections of the US government themselves subscribe to the MAD thesis. In their view, meltdown of the world’s financial system, in the long run, further consolidates the interests of the United States. Other economies would be more damaged by economic turmoil than the United States. As the fiat system crumbles, leaders take the initiative and launch a new global currency. The currency, they claim brings stability to the global economy by having a common unit of account. The economies of other countries become increasingly tied to policy decisions from Washington.

In this scenario, the US government is able, but unwilling to avert the spread of contagion for political and economic reasons.

Scenario 4: General Incompetence

While governments and their central banks may wish to bailout the fiat system, they may lack the insight and skill to do so. History is full of devastation wrecked by the mismanagement of economies. For example, during its currency crisis in 1994, the Mexican government had $30 billion in foreign exchange reserves, enough to buy up every peso in existence twice over. Reduction of base money supply would have supported the peso’s value at 3.11 to the dollar it has been trading at the year before. Instead, under Miguel Mancera, the director of Mexico’s central bank, the bank undertook pointless “sterilized” interventions, selling dollars and buying peso debt. Mexico’s foreign reserves’ trickled away and by January 1995 the peso was devalued to 5.5 per dollar.[4]

Similar to scenario 1, scenario 4 argues that general incompetence may prevent governments and central banks to effectively deal with the next systemic event.

Exchanges & Clearing Houses

The failure of major exchanges and clearing houses prevents normal market operation. Price discovery for equities, futures, commodities and other financial products ceases. The value of these assets becomes ambiguous at best.

Failure occurs for a number of reasons including:

* The default of counterparties in clearing house transactions

* Government debt is no longer acceptable as collateral.

* The recall of loans to the operating company by troubled banks

For example, Intercontinental Exchange (NYSE: ICE) operates 12 regulated exchanges and marketplaces. This includes ICE futures exchanges in the United States, Canada, and Europe, the Liffe futures exchanges in Europe, the New York Stock Exchange, equity options exchanges and OTC energy, credit, and equity markets.[5] The New York Stock Exchange is by far the world’s largest stock exchange by market capitalization of its listed companies at US$30.1 trillion as of February 2018.[6]

ICE also owns and operates 6 central clearing houses: ICE Clear U.S., ICE Clear Europe, ICE Clear Singapore, ICE Clear Credit, ICE Clear Netherlands, and ICE NGX.

The company’s 2018 Annual Report states:

“There are risks inherent in operating clearinghouses, including exposure to the market and counterparty risk of clearing members, market liquidity risks, defaults by clearing members and risks associated with custody and investing margin or guaranty fund assets provided by clearing members to our clearinghouses, which could subject our business to substantial losses…. Furthermore, the default of any one of the clearing members could subject our business to substantial losses and cause our customers to lose confidence in the guaranty of our clearinghouses.”[7]

As more financial institutions become insolvent the default rate of ICE clearing members increases leading to the inability of the clearinghouse to function through lack of solvent counterparties. Confidence falls.

“If a number of clearing members substantially reduce their open interest or default, the concentration of risks within our clearinghouses will be spread among a smaller pool of clearing members, which would make it more difficult to absorb and manage risk in the event of a further clearing member’s default.”[8]

Loss of confidence in sovereign currencies or debt puts pressure on clearinghouse members to post additional margin at a time when they themselves face an increasing liquidity crisis:

“If the value of the (treasury) securities declines significantly, our clearinghouses will need to collect additional margin or guaranty fund contributions from their clearing members, which may be difficult for the members to supply in a time of financial stress affected by an actual or threatened default by a sovereign government.”[9]

Like many other listed financial institutions, Intercontinental Exchange carries significant debt. If lenders call in loans the company would be placed under considerable financial stress:

“As of December 31, 2018, we had $7.4 billion of outstanding debt. This level of indebtedness could have important consequences to our business, including making it more difficult to satisfy our debt service obligations, increasing our vulnerability to general adverse economic and industry conditions.”[10]

Equities

The contagion first spreads through the financial sector. Financial companies call in their loans to other banks and insurers in an effort to boost their balance sheets. This exacerbates the liquidity crisis for all. Investor confidence falls as the extent of outstanding exposure from derivative contracts remains unquantifiable. There appears no limit to the risk.

Next, the contagion spreads to other sectors as banks call in their commercial loans. US corporate debt surged 50% from 2009 to $10 trillion in 2019. As banks call in the debt, companies find themselves financially stressed without access to liquidity. Falling share prices increases debt to equity ratios resulting in downgrades in credit ratings. Re-financing of debt, if available at all is at interest rates higher than falling cash flow can sustain.

With falling stock prices, loss of lines of credit and reduced cash flow non-financial companies file for bankruptcy.

Bonds

Corporate bonds are downgraded as companies implode through the loss of banking relationships and falling share prices. Many companies default and the paper becomes worthless. As confidence in the bond market falls bondholders themselves experience a liquidity crisis as demand for the asset evaporates.

Market Makers

For the exchanges that remain, liquidity dries up as the financial institutions that act as market makers are no longer able to perform their role as counterparties to trades. The orderly functioning of the market ceases. Price discovery becomes a function of any buyer in the market. Once liquid assets including exchange traded funds such as the S&P500 Index become illiquid. Many lose value altogether.

Exchange Traded Funds

Along with a loss of liquidity, ETFs lose the ability to operate as the financial institutions required for their day to day business cease trading.

For example, The SPDR® Gold Trust requires The Bank of New York Mellon to function as the trustee of the Trust. HSBC Bank plc operates as the custodian of the Trust and State Street Global Advisors Funds Distributors, LLC as the marketing agent.[11] As these institutions themselves become insolvent they are unable to fulfil their respective roles and shares in the Trust are no longer able to maintain their peg with gold. Unlike ownership of the physical metal, Gold Trust shares become worthless.

Pensioners

Pre-event equity and bonds provided the lion’s share of institutional asset allocation. With the demise of these assets seemingly “balanced” pension portfolios demonstrate just how exposed they are. Millions find their pensions sharply reduced or vanished altogether. What once looked like a secure income stream for retirement has all but disappeared.

Ninety per cent of the CalPERS portfolio, the largest pension fund in the United States serving 1.9 million pensioners is exposed to systemic risk. Its beneficiaries see their pensions reduced to 10% of their original value. Dependents on the Austin City Police Retirement Scheme do better with 15% of the portfolio outside the fiat system.

Political Unrest

Bankruptcy of companies and economic downturn leads to large increases in unemployment. Inflation undermines any remaining economic stability. Families focus on meeting their most basic day to day needs. The failure of financial institutions and government leads to the rise of populist leaders and civil unrest. Capital exits in search of assets independent of the fiat system further reducing liquidity. Survival has replaced sound financial planning as peoples’ number one priority. No one considers the cause of their troubles to be one of design, or that Google daily demonstrates the low-risk alternative to centralized finance with its distributed networks of servers.

Please email comments and suggestions for improvement to: branton@kenton-dau.com.

[1] https://www.visualcapitalist.com/worlds-money-markets-one-visualization-2017/

[2] https://www.nber.org/papers/w18727

[3] Nathan Lewis provides a good history of the repetitive failure of fiat currencies in the opening chapters of Gold, The Final Standard https://newworldeconomics.com/gold-the-final-standard/

[4] Nathan Lewis, Gold the Once and Future Money, pp 393–394.

[5] https://en.wikipedia.org/wiki/Intercontinental_Exchange

[6] https://en.wikipedia.org/wiki/New_York_Stock_Exchange

[7] https://otp.tools.investis.com/clients/us/intercontinental_exchange_group2/SEC/sec-show.aspx?FilingId=13198867&Cik=0001571949&Type=PDF&hasPdf=1

[8] Ibid.

[9] Ibid.

[10] Ibid.

[11] https://www.spdrgoldshares.com/media/GLD/file/SPDR-Gold-Trust-Prospectus-20190908.pdf

The Capital

The Capital (former Altcoin Magazine) is a social financial news aggregator powered by Bitcoin

Simon Paige

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The Capital

The Capital (former Altcoin Magazine) is a social financial news aggregator powered by Bitcoin

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