I want to give up a primer on derivatives. These are esoteric contracts generally linking two or more securities in a “If … then” scenario.
Theses instruments have a notional value in the 100s of trillions of dollars — with no one knowing the true market cap of the entire market.
Some will say its a zero-sum game but that’s only the case if all contracts execute at the same time. That’s not how it works. A subset of derivatives craters as a Lehman Bros. implodes and then squeezes liquidity out of the market causing crashes in stocks and bonds.
So with that said, we have two very different news events tied directly to the derivative market.
The first deals with Deutsche Bank. The German bank has a huge exposure to the derivative market, with some putting its book at $60T alone.
Well Deutsche Bank is now offering in Europe a 90-day CD with an interest rate of 5%. In a zero-interest rate environment, 5% return to bring cash into the bank, has to send up a flare that something is wrong with DB.
This is not the first canary in the coalmine for DB. The stock is down 45% over the last year and 30% just this year.
The bank is struggling to get liquidity into its coffers through this offer, but the rate tells you how desperate the bank is and also what a credit risk it may be for its new savers.
The second news event is the Federal Reserve earlier this month issued a new decree for derivative contracts.
New contracts written will have a 48-hour cooling off period before a derivative contract can be called in and collected on. The measure is to take effect next year, but the language for the contract is already in place.
The idea is to give the central banks time to bail out a troubled bulge-bracket bank or important company before liquidity is yanked in a fire sale due to insolvency.
This again is a perversion of capitalism as it takes bankruptcy out of the equation and re-enforces the “Too Big To Fail” conspiracy.
I’m not sure what will be the first match that ignites the derivative market, but from DB’s actions it appears it might be a failed stress test, due to lack of capital at the German bank.
So when you hear a problem in the derivative market, don’t say it doesn’t affect me. Because it most certainly will.