The Looming Derivative Crisis

The comments below are an edited and abridged synopsis of an article by Alasdair Macleod

One of the scares at the time of the Lehman crisis was that insolvent counterparties risked collapsing the OTC derivative complex. Because of this, AIG, a non-bank originator of many derivative contracts, had to be bailed out by the Fed. Fortunately a derivative crisis was averted, and by consolidating some of the outstanding positions, the gross value of OTC derivatives was reduced.

The Looming Derivative Crisis | BullionBuzz
Building of the bank drowning in the sea.

In June 2019, global OTC contracts outstanding were still $640 trillion. But in bank balance sheets only a net figure is usually shown, and you have to search the notes to financial statements to find evidence of gross exposure. It is the gross that matters, because each contract bears counterparty risk, sometimes involving several parties, and derivative payment failures could make the payment failures now evident in disrupted industrial supply chains look like small potatoes.

Deutsche Bank’s 2019 balance sheet is an example of how they are accounted for in commercial banks. It conceals derivative exposure under the headings ‘Trading assets’ and ‘Trading liabilities’ on the balance sheet. You have to go into the notes to discover that under Trading assets, derivative financial instruments total €80.848bn, and under Trading liabilities, derivative financial instruments total €81.910bn, a difference of €1.062bn This is relatively trivial for a bank with a balance sheet of €777bn.

Deutsche Bank is not alone in presenting derivative risk in this manner. As a weak link, it is an illustration of risks in the banking system. Since the Lehman crisis, its senior management has been on the back foot, retreating from businesses they could neither control nor understand. They have also made public mistakes in precious metals.

Up for discussion: gold derivatives in crisis; the mechanics of gold derivative trading; how the ending of the gold derivative scam started; and broader implications of the failure of gold derivatives.

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