We have seen chaos break out on markets and these sudden losses incurred by megabanks all over the world at once could be a pre-curser for what is to come
I wanted to discuss Centralia Pennsylvania, in 1932, the day after Memorial Day, someone noticed smoke rising from the landfill. The town quickly put it out.
A few days later, however, the firemen found a disturbing problem: a hole near the landfill led to the mining passages that trailed under the town. The fire spread underground, feasting on a large supply of unmined coal.
This did not prompt the panic you might expect. In fact, the people of Centralia initially adapted: “Sure, the earth glowed blue from methane, like the hills themselves were suffocating.” With similar attitudes, people simply lived …
In 1979 John Coddington, mayor and gas station owner, noticed the temperature of his underground fuel tanks had risen to 172 degrees. Still, everyone just ignored it, then in 1981, a twelve-year-old nearly fell into a 150-foot methane-filled pit. Fortunately, he grabbed some tree roots, and survived.
The moral of the story is no one is talking about the massive bonfire in our economy. We could talk for hours about who started this fire, but that’s for another day. But they have set the earth on fire with the rapid volume of money printing and it is burning so hot they are starting to look for explanations and distractions.
What happened in markets yesterday is a perfect demonstration of the ground beginning to crumble after a decade of willful ignorance.
As Bloomberg reports, much of the leverage used by Hwang’s Archegos Capital was provided by banks including Nomura and Credit Suisse – who have most recently admitted huge losses – as CFDs, which are made off exchanges, allow managers like Hwang to amass stakes in publicly traded companies without having to declare their holdings (far in excess of the 5% stakes that require regulatory reporting).
Crucially, as Bloomberg notes, this means Archegos may never actually have owned most of the underlying securities – if any at all – as the CFD is akin to a privately-arranged (i.e. off exchange and bespoke) futures contract where the differences in the settlement between the open and closing trade prices are cash-settled (there is no delivery of physical goods or securities with CFDs).
What makes the situation worse is that Archegos reportedly took positions in these CFDs with various prime brokers – and because these positions are by their nature not centrally cleared or aggregated, this left prime broker X unaware of their client’s exposures with prime broker Y… which in this case was huge.
The leverage Hwang was given made him look like a trading genius as the various positions he took were pumped and pumped (and helped by gamma-squeezers) but now look like a reckless gambling fool as the bets collapsed.
CFDs linked to stocks (with a gross market value of around $282 billion at end June 2020) are among bespoke derivatives that investors trade privately between themselves, or over-the-counter, instead of through public exchanges. This is exactly the kind of hidden risk that amplified the losses during the 2008 financial crisis.
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