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DERIVATIVES: TIC TOCK, TICK TOCK

DERIVATIVE:
1. ...A financial instrument traded on (CME) or off an exchange (OTC), the price of which is
directly dependent upon the value of one or more underlying securities, equity indices, debt
instruments, commodities, other derivative instruments, or any agreed upon pricing index or
arrangement...
2. A bet on a bet on a bet, yet on another bet with the underlying instrument a Ponzi secured
with paper promises valued on no fundamentals.... JRC
BACKGROUND:
I am not sure how to approach this article, as I am far from experienced in regards to derivatives,
however, after the 2008 Great Financial Crisis (GFC), I began reading about the underlying
causes of the GFC starting with Naomi Klein's Shock Doctrine , Yves Smith's ECONned,
and finally David Stockman's The Great Deformation. I discovered that large corporations
were using derivatives as a means to hedge against risk with a strong usage found in
banks/insurance companies. Both Stockman and Smith indicated that it was AIG, under the
tutelage of Hank Greenberg that dramatically increased the use of the Credit Default
Swaps/Collateralized Debt Obligations derivative over the years as a tool to hedge AIG's risk:
risk particularly associated with subprime mortgages. Eventually, and as one can easily imagine,
Greenberg got greedy; collateral collapsed, and Bear Sterns fell as a result of AIGs hubris; hence
the Great Financial Crisis.
While derivatives have been in existence much longer than most think (Mesopotamian), the use
of derivatives in contemporary times became much more prevalent through 2003-2007
particularly as the Black Scholes pricing model became available. Although somewhat already
denuded, the Glass-Steagall Act separating commercial and investment bank operations was
repealed by President Clinton in 1999. As a result, and despite grave warnings by Brooksley
Born (Chair of the CFTC), derivatives starting trading OTC becoming an immense tool for banks
to ostensibly hedge risk. However, exponential use of derivatives since the GFC has now
become what some consider being a $600 trillion time bomb. Keep in mind, the World's Gross
Product is ~ $78.28 trillion in nominal terms ($107.5 trillion in purchase power parity), thus
$600 trillion is a significant and troubling number. Nevertheless, here are additional issues that
concern me:

PROBLEMS:
Size: I have been reading about derivatives for years without finding a source for an
accurate accounting for the total exposure in existence. As mentioned above some think
$600 trillion while others suggest the balance to be $1.2 quadrillion. Yes, quad, an
enormous amount.
Transparency: It is next to impossible to ascertain the derivative exposure of various
corporations in an expeditious way (without obtaining 10-Ks). There just does not
appear to be a reliable source (retail) for obtaining this information. AlphaSense is a firm
that advertises on LI indicating that they offer a service that professes, AlphaSense is an
advanced search web platform that allows our customers to input keywords and topics
to intelligently search across millions of company filings, investor presentations,
transcripts, press releases and broker research. They offered a free trial, but when I had
an email exchange with a SVP of sales, he indicated there was a $6,000 annual
subscription and did I have a corporate name. I have neither and disclosing the writing of
this article to them did little to gain the free trial so I am not sure of their capabilities.
Incidentally, I did contact a number of LI connections asking their thoughts or
suggestions in terms of a reliable data source, but no one had any strong suggestions.
One can go to the BIS, ISDA, or the CME for more macro statistics, but you will not find
much data regarding an individual corporation.
Systemic Risk: Most are aware that as a result of the GFC many large banks were
bailed out by the US government (taxpayers). Therefore, it would be understandable
that one would consider that banks are now less risky and do not represent a threat to the
Worlds financial system as they did in 2008. Yet, this may not be true. According to the
Federal Accounting Standard Board (FASB) rules, banks are not required to list most
mortgage-linked bonds on their balance sheet (See here). A 2013 survey indicated that if
four of the top too big to fail (TBTF) banks were to list these assets, their balances sheets
would double in size. This begs the question: What is really off-balance for banks and
what is the risk of said assets? This is very important in that there is an
interconnectedness among these banks that collateral collapse could experience a
daisy chain event. Should this occur and a default is triggered another issue may arise
in the form of supply of bond issues carrying quality ratings necessary to replace the
defaulted issues.
Here is the rub. Banks, with support of the Federal Reserve sustained efforts to have
revisions enacted to Dodd-Frank of 2010. In 2014, provisions in the Cromnibus Act
effectively rolled-back Dodd-Frank legislation that required banks to separate
derivative activity from traditional banking. This opened the door for banks to hold risky
derivative assets in subsidiaries that have the guarantee of the FDIC. And, since the

Bankruptcy Act of 2005 moves derivative defaults to a senior position over un-secured
creditors (depositors), the FDIC would be obliged to pay the exposed bondholders prior
to paying depositors.
Nation Busting. What was once a conspiracy theory that became conspiracy fact, TBTF
banks are now under a SEC probe for credit default swap (CDS) collusion. Already
convicted and fined in LIBOR manipulation, money laundering, and currency
manipulation, the banks colluded with each other and associated industry professionals to
manipulate the price the prices of CDS of different sovereignties (Greece) resulting in
default. It seems that these banks operate with impunity of the law considering the
associated costs of legal fees and government fines a cost of doing business.
SUMMARY:
While not as definitive as I would prefer, I must say that this article was difficult to write in that I
found the Rabbit Hole quite deep when researching derivatives. Practically every document I
read contained links to additional articles that opened the proverbial can of worms with more
disturbing data relating to abuses surrounding derivatives. I am sure there are justifiable uses of
various derivative structures; however, the question remains does the risk of derivatives
outweigh the benefit?
NOTE:
My intention in posting this article is to open a dialogue regarding the risks of derivatives to the
financial system; therefore, I look forward to any clarifications or constructive comments LI
members may offer. Thanks.

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