{"id":254979,"date":"2024-02-19T12:00:19","date_gmt":"2024-02-19T12:00:19","guid":{"rendered":"https:\/\/www.transcend.org\/tms\/?p=254979"},"modified":"2025-01-10T15:00:39","modified_gmt":"2025-01-10T15:00:39","slug":"defusing-the-derivatives-time-bomb-some-proposed-solutions","status":"publish","type":"post","link":"https:\/\/www.transcend.org\/tms\/2024\/02\/defusing-the-derivatives-time-bomb-some-proposed-solutions\/","title":{"rendered":"Defusing the Derivatives Time Bomb: Some Proposed Solutions"},"content":{"rendered":"

16 Feb 2024 – The \u201cprotected class\u201d is granted \u201csafe harbor\u201d only because their bets are so risky that to let them fail could crash the economy. But why let them bet at all?<\/em><\/p><\/blockquote>\n

This is a sequel to a 17 Jan\u00a0TMS<\/em> article titled \u201cCasino Capitalism and the Derivatives Market: Time for Another \u2018Lehman Moment\u2019?<\/a>\u201d, discussing the threat of a 2024 \u201cblack swan\u201d event that could pop the derivatives bubble. That bubble is now over ten times the GDP of the world and is so interconnected and fragile that an unanticipated crisis could trigger the collapse not just of the bubble but of the economy. To avoid that result, in the event of the bankruptcy of a major financial institution, derivative claimants are put first in line to grab the assets \u2014 not just the deposits of customers but their stocks and bonds. This is made possible by the Uniform Commercial Code, under which all assets held by brokers, banks and \u201ccentral clearing parties\u201d have been \u201cdematerialized\u201d into fungible pools and are held in \u201cstreet name.\u201d<\/p>\n

This article will consider several proposed alternatives for diffusing what Warren Buffett called a time bomb waiting to go off. That sort of bomb just detonated in the Chinese stock market, contributing to its fall; and the result could be much worse in the U.S., where the stock market plays a much larger role in the economy.<\/p>\n

The Chinese Derivative Crisis<\/strong><\/p>\n

A Jan. 30 article on\u00a0Bloomberg News notes<\/a>\u00a0that \u201cChinese stocks\u2019 brutal start to the year is being at least partly blamed on the impact of a relatively new financial derivative known as a snowball. The products are tied to indexes, and a key feature is that\u00a0when the gauges fall below built-in levels, brokerages will sell their related futures positions.\u201d<\/p>\n

Further details are in a Jan. 23rd<\/sup>\u00a0article titled \u201c\u2019Snowball\u2019 Derivatives Feed China\u2019s Stock Market<\/a>\u00a0Avalanche.\u201d It states, \u201cChina\u2019s plunging stock market is leading to losses on billions of dollars worth of derivatives linked to the country\u2019s equity indexes, fuelling further selling as retail investors offload their positions\u2026. Snowball products are similar to the index-linked products sold in the 2008 financial crisis, with investors betting that U.S. equities would not fall more than 25% or 30%,\u201d which they did.<\/p>\n

Chinese shares rose<\/a>\u00a0on Feb. 6, as officials took measures to prop up the ailing market, including imposing new \u201czero tolerance\u201d\u00a0curbs for malicious short selling<\/a>.<\/p>\n

The Greater U.S. Threat<\/strong><\/p>\n

The Chinese stock market is much younger and smaller than that in the U.S., with a much smaller role in the economy. Thus\u00a0China\u2019s economy remains relatively protected<\/a>\u00a0from disruptive ups and downs in the stock market. Not so in the U.S., where speculating in the derivatives casino brought down international insurer AIG and investment bank Lehman Brothers in 2008, triggering the global financial crisis of 2008-09. AIG had to be bailed out by the taxpayers to prevent collapse of the too-big-to-fail derivative banks, and Lehman Brothers went through a messy bankruptcy that took years to resolve.<\/p>\n

In a December 2010 article on\u00a0Seeking Alpha<\/em>\u00a0titled \u201cDerivatives: The Big Banks\u2019 Quadrillion-Dollar Financial Casino<\/a>,\u201d attorney Michael Snyder wrote, \u201cderivatives were at the heart of the financial crisis of 2007 and 2008, and whenever the next financial crisis happens, derivatives will undoubtedly play a huge role once again\u2026. Today, the world financial system has been turned into a giant casino where bets are made on just about anything you can possibly imagine, and the major Wall Street banks make a ton of money from it. The system \u2026 is totally dominated by the big international banks.\u201d<\/p>\n

The Speculators Dominate the Regulators<\/strong><\/p>\n

In a 2009 Cornell Law Faculty publication titled\u00a0How Deregulating Derivatives Led to Disaster, and Why Re-Regulating Them Can Prevent Another<\/a>, Prof. Lynn Stout proposed stabilizing the market by returning to 20th\u00a0century derivative rules. She noted that derivatives are basically wagers or bets, and that before 2000, the U.S. and U.K. regulated derivatives primarily by a common\u2010law rule known as the \u201crule against difference contracts.\u201d She explained:<\/p>\n

The rule against difference contracts did not stop you from wagering on anything you liked: sporting contests, wheat prices, interest rates. But if you wanted to go to a court to have your wager enforced, you had to demonstrate to a judge\u2019s satisfaction that at least one of the parties to the wager had a real economic interest in the underlying and was using the derivative contract to hedge against a risk to that interest.\u2026 Using derivatives this way is truly hedging, and it serves a useful social purpose by reducing risk.<\/p>\n

\u2026 Under the rule against difference contracts and its sister doctrine in insurance law (the requirement of \u201cinsurable interest\u201d), derivative contracts that couldn\u2019t be proved to hedge an economic interest in the underlying were deemed nothing more than legally unenforceable wagers.<\/p>\n

\u2026 Hedge funds, for example, should really call themselves \u201cspeculation funds,\u201d as it is quite clear they are using derivatives to try to reap profits at the other traders\u2019 expense.<\/p><\/blockquote>\n

The rule against difference contracts died in 2000, when the US embraced wholesale deregulation with the passage of the\u00a0Commodity Futures Modernization Act<\/a>\u00a0(CFMA):<\/p>\n

The CFMA not only declared financial derivatives exempt from CFTC or SEC oversight, it also declared all financial derivatives legally enforceable. The CFMA thus eliminated, in one fell swoop, a legal constraint on derivatives speculation that dated back not just decades, but centuries. It was this change in the law\u2014not some flash of genius on Wall Street\u2014that created today\u2019s $600 trillion financial derivatives market.<\/p><\/blockquote>\n

The Casino Gets Special Privileges<\/strong><\/p>\n

Not only are speculative derivatives now legally enforceable, but under the Bankruptcy Act of 2005,\u00a0derivative securities enjoy special protections<\/a>. Most creditors are \u201cstayed\u201d from enforcing their rights while a firm is in bankruptcy, but many derivative contracts are exempt from these stays. Similarly,\u00a0under the Dodd Frank Act<\/a>\u00a0of 2010, derivative claimants have \u201csuper-priority\u201d in the bankruptcy of a financial institution. They are privileged to claim collateral immediately without judicial review, before bankruptcy proceedings even begin. Depositors become \u201cunsecured creditors\u201d who can recover their funds only after derivative, repo and other secured claims, assuming there is anything left to recover, which in the event of a major derivative crisis would be unlikely.<\/p>\n

That\u2019s true not only of the deposits in a bankrupt bank but of stocks, bonds and money market funds held by a broker\/dealer that goes bankrupt. Under the Bankruptcy Act of 2005 and Sections 8 and 9 of the Uniform Commercial Code (UCC), \u201csafe harbor\u201d is provided to entities described in court documents as \u201cthe protected class.\u201d The customers who purchased the assets have only a \u201csecurity entitlement,\u201d a weak contractual claim to a pro rata share of a residual pool of fungible assets all held in the name of Cede & Co., the proxy of the Depository Trust and Clearing Corp. (DTCC). As Wall Street financial analyst\u00a0John Rubino put it<\/a>\u00a0in a Jan. 27 podcast:<\/p>\n

What we used to think of as a bank bail-in where they take your deposit in order to support a failing bank, that is now spread across the entire financial economy where whatever you have in an account anywhere can just disappear, because they\u2019re going to transfer ownership of it to these big dominant entities out there in the financial system that need those assets in order to keep from blowing up.<\/p><\/blockquote>\n

Derivative speculators are considered \u201csecured\u201d because they post a portion of what they could wind up owing as \u201cmargin,\u201d but why that partial security is superior to the 100% security posted by the depositor or purchaser is not explained. The \u201cprotected class\u201d is granted \u201csafe harbor\u201d only because their bets are so risky that to let them fail could crash the economy. But why let them bet at all?<\/p>\n

The Solution of the Regulators<\/strong><\/p>\n

The fix of the G20 leaders following the global financial crisis, however, was to force banks to clear over-the-counter derivatives through central counterparties (CCPs), which stand between buyer and seller and protect either party if the other blows up. By March 2020, 60% of credit default swaps and 80% of interest rate swaps were centrally cleared. The problem, as noted in\u00a0a December 2023 publication by the Bank for International Settlements<\/a>, is that these measures taken to protect the system can actually amplify risk.<\/p>\n

CCPs tend to ask for more collateral than banks did in the pre-crisis world; and when a CCP hikes its initial margin requirement to cover the risk of default, this applies to everyone in the market, meaning cash calls are synchronized. As explained in\u00a0a May 2022 Reuters article<\/a>:<\/p>\n

It\u2019s logical that CCPs ask for more collateral during a panic: that\u2019s when defaults are most likely. The problem is that margin calls seem to have made things worse. In March 2020, for example, a so-called \u201cdash for cash\u201d saw investors liquidate even prime money-market funds and U.S. Treasury securities.<\/p>\n

\u2026 [R]ampant margin calls have intensified a financial panic twice in as many years, with central banks effectively bailing out markets in 2020. That\u2019s better than in 2008, when taxpayers had to step in. But the problem of margin calls remains unsolved.<\/p>\n

\u2026 Central counterparty (CCP) clearing houses should consider asking clients for more collateral during good times to reduce the risk of destabilising margin calls during a financial panic, a Bank of England official said on May 19.<\/p><\/blockquote>\n

Yet all this, as Michael Snyder observes, is to allow the big international banks to run the largest derivatives casino that the world has ever seen. Why not just shut down the casino? Prof. Stout\u2019s suggested solution is for Congress to return to the pre-2000 rule under which speculative derivative bets were not enforceable in court. That would include reversing the \u201csuperpriority\u201d privileges in the Bankruptcy Act of 2005 and the Dodd-Frank Act. But it won\u2019t be a quick fix, as Wall Street and our divided Congress can be expected to put up a protracted fight.<\/p>\n

What If the DTCC Goes Bankrupt?<\/strong><\/p>\n

In a 2015 law review article titled \u201cFailure of the Clearinghouse: Dodd-Frank\u2019s Fatal Flaw?<\/a>,\u201d Prof. Stephen Lubben points to a more ominous risk from pushing all derivatives onto exchanges; and that concern is shared by former hedge fund manager David Rogers Webb in his 2024 book \u201cThe Great Taking<\/a>.\u201d The exchanges are supposed to be safer than private over-the-counter trades because the exchange steps in as\u00a0market maker<\/a>, accepting the risk for both sides of the trade. But in a general economic depression, the exchanges themselves could go bankrupt. No provision for that is made in the Dodd-Frank Act, which purports to decree \u201cno more bailouts.\u201d Still, reasons Prof. Lubben, the government would undoubtedly step in to save the market from collapse.<\/p>\n

His proposed solution is for Congress to make legislative provision for nationalizing any bankrupt exchange, brokerage or Central Clearing Counterparty before it fails. This is something to which our gridlocked Congress might agree, since under current circumstances it would not involve any major changes, wealth confiscation or new tax burdens; and it could protect their own fortunes from confiscation if the DTCC were to go bankrupt.<\/p>\n

Other Possible Federal Solutions<\/strong><\/p>\n

Another alternative that not only could work but could fix Congress\u2019s budget problems at the same time is to impose a 0.1% tax on all financial transactions. See Scott Smith,\u00a0A Tale of Two Economies: A New Financial Operating System<\/a>, showing that U.S. financial transactions (the financialized economy) are over $7.6 quadrillion, more than 350 times the U.S. national income (the productive economy). See my earlier article summarizing all that\u00a0here<\/a>. On a financial transaction tax curbing speculation in derivatives, see also\u00a0here<\/a>,\u00a0here<\/a>\u00a0and\u00a0here<\/a>.<\/p>\n

There are other possible solutions to customer title concerns. There is no longer a need for the archaic practice of holding all securitized assets in the street name of Cede & Co. The digitization of stocks and bonds was a reasonable and efficient step in the 1970s, but today digital cryptography has gotten so sophisticated that \u201csmart contracts\u201d can be attached by blockchain-like distributed ledger technology (DLT) to digital assets, tracking participants, dates, terms and other contractual details. The states of Delaware and Wyoming have explored maintaining corporate lists of stockholders on a\u00a0state-run blockchain<\/a>; but predictably, the measures were opposed. The practice of holding assets in street name has\u00a0proven very lucrative<\/a>\u00a0for the DTCC\u2019s member brokers and banks, as it facilitates short selling and the \u201crehypothecation\u201d of collateral.<\/p>\n

In October 2023,\u00a0the DTCC reported<\/a>\u00a0that it has been exploring adopting DLT; but the goal seems only to be speedier and safer trades. No mention was made of returning registered title to the purchasers of the traded assets, which\u00a0could be done<\/a>\u00a0with distributed ledger technology.<\/p>\n

South Dakota\u2019s Innovative Solution<\/strong><\/p>\n

The most readily achievable solution is probably that in a South Dakota bill filed on Jan. 29.\u00a0 The bill is detailed in a Feb. 2 article titled \u201cYou Could Lose Your Retirement Savings in the Next Financial Crash Unless Others Follow This State\u2019s Lead<\/a>\u201d, which observes:<\/p>\n

\n

\u2026 [I]f your broker \u2026 were to go bankrupt, the broker\u2019s secured creditors (the people to whom the broker owes money) would be empowered to take the investments that you paid for in order to settle outstanding debts\u2026.<\/p>\n

To avoid a catastrophe in the future, a nationwide movement is desperately needed to alter the existing Uniform Commercial Code. Of course, that won\u2019t be easy to accomplish, especially because bank lobbyists and other powerful financial interests will almost certainly fight kicking and screaming to stop policymakers from taking away their advantage over consumers.<\/p>\n

The good news is, this \u201cgreat taking\u201d can be stopped at the state level. Americans don\u2019t need to count on a divided Congress to get the job done. Because the UCC is state law, state lawmakers can take concrete steps to restore the property rights of their constituents and protect them in the event of a financial crisis.<\/p>\n

On Monday, South Dakota legislators introduced a bill that would do just that. The legislation would ensure that individual investors have priority over securities held by brokerage firms and other intermediaries.<\/p>\n

It would also alter jurisdictional provisions so that cases are determined in the state of the individual investor, rather than the state of the broker, custodian or clearing corporation. This would ensure that individual investors are able to rely on the laws of their local state.<\/p><\/blockquote>\n<\/blockquote>\n

Hopefully, other states will follow South Dakota\u2019s lead. Tennessee, for one, is reported to have such a bill in the works.<\/p>\n

________________________________________<\/em><\/p>\n

\"\"<\/a> Ellen Brown is a member of the <\/em>TRANSCEND Network for Peace Development Environment<\/a>, an attorney, founder\/chairperson of the\u00a0<\/em>Public Banking Institute<\/a>, and author of thirteen books including\u00a0<\/em>Web of Debt<\/a>,\u00a0The Public Bank Solution<\/a>, and\u00a0<\/em>Banking on the People: Democratizing Money in the Digital Age<\/a>.\u00a0Her articles are at\u00a0<\/em>ellenbrown.com<\/em><\/a><\/p>\n

 <\/p>\n

Go to Original \u2013 ellenbrown.com<\/a><\/p>\n","protected":false},"excerpt":{"rendered":"

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