'..I have no doubt that derivatives and associated “dynamic” trading strategies will play a major destabilizing role in the unfolding global financial crisis.'<blockquote>'..the Chinese were actively supporting the ruble and Russian debt on Wednesday and Thursday..
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Long-time readers know I am no fan of Credit and market “insurance.” Cheap insurance invariably fuels excess on the upside of the boom, only later to ensure dislocation when the Bubble burst. Basically, Credit and market risks are uninsurable – they are neither random nor independent events (such as auto accidents and house fires)..
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The Fed and global central bankers have had a profound role on derivatives markets. I would argue that many of these key financial “insurance” markets are viable only because of central bank assurances of “liquid and continuous” markets. Certainly, the proliferation of these types of products would not be possible if not for the view that central banks will protect against market crisis. Who would write market and Credit insurance if they lacked confidence in central banks underpinning the markets?
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Actually, I think “do whatever it takes” central bank "money" printing coupled with zero rates has spurred risk-taking and a resulting historic Bubble throughout high-yield debt. CDS and derivatives more generally have played a profound role – creating significant unappreciated leverage on the upside of the boom. Now, with the global Bubble bursting, this “insurance” marketplace holds the potential to incite an abrupt tightening of Credit conditions (has it already commenced?) On the one hand, a widening of spreads and higher CDS prices will lead to some unwinding of derivative-related leverage. Worse yet, the proliferation of “out-of-the-money” option “Armageddon” protection will dictate that those that have written these derivatives short securities as market and Credit backdrops deteriorate.
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When the Russia currency and bond collapse unfolded in October 1998, derivative trading strategies played a significant role. Hedging and speculation created overwhelming market selling pressure and resulting illiquidity. In the end, Russian banks that had written ruble insurance collapsed right along with the ruble and the Russian debt market. I have no doubt that derivatives and associated “dynamic” trading strategies will play a major destabilizing role in the unfolding global financial crisis.
And more from the FT: “The surge in trading of credit index options stands in stark contrast to the CDS market itself, which has been shrinking dramatically since the financial crisis. The derivatives were widely blamed for exacerbating the crisis and have since come under tighter regulatory scrutiny and control, including a requirement that they be ‘cleared’ through exchange-like central counterparties. Unlike CDS, options on CDS indices are not yet required to be centrally cleared. ‘Every single month in 2014 experienced volume growth compared to the same period in 2013, which suggests the growth was not seasonal, or in response to one-off events in 2014,’ the Citi analysts said. “Credit options are currently one of the fastest growing areas in credit derivatives.”
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..this dynamic now plays a critical role in prolonged “blow off” excesses. Importantly, when the Core begins to succumb to the faltering Bubble this massive derivatives (hedging/speculating) trade will overhang system stability. The market cannot hedge market risk. There’s no one with the wherewithal to “take the other side of the trade.” The “other side” is instead a computer model, programmed to dump sell orders into declining markets. Liquidity will inevitably become a critical problem.
A year ago this week I was invited to participate in a company event – a bull vs. bear debate. I presented my Bubble thesis, arguing against the bullish “house” view. I posed what I am convinced is a fundamental question: “Is the underlying money and Credit sound or unsound?” I also included the following: “I do not sit around worrying about my reputation or my career prospects. I am driven by two things: analytical integrity and the quality of my analysis.” I would have it no other way.'
- Doug Noland,
Bo, Bo, December 19, 2014</blockquote>
Context<blockquote>
'..IMF .. Russia needs the help..''Russia has not lived up to its promises..'</blockquote>