This One Sector Could Trigger a Financial Crisis
With the Federal Reserve essentially saying it will do whatever it takes to protect the financial system—and with the stock market doing great right now—one might assume that the risk of a major financial crisis is small. But don’t get too complacent.
Yes, on the surface, everything seems normal. And we live in an environment where even a small amount of economic turbulence will be met with extreme force from central banks. They just don’t want anything to break now.
However, if you look underneath and dig deep into the details, you’ll find a lot of problems. These problems say a financial crisis could happen. It’s just a matter of time.
One place that’s worth looking at is the derivatives market.
Learn From the Archegos Fiasco
Before going into more detail, something recently happened that I need to address. A hedge fund/family office by the name of Archegos Capital Management, LP went through a massive margin call.
The fund had built up a leveraged position using complex derivatives. The fund did it very quietly. Sadly, the trades that Archegos placed needed to be closed. And it turns out the massive leverage was provided by major banks around the world. Now those banks are reporting that they will have massive losses in the coming quarters.
Credit Suisse Group AG (NYSE:CS), a major bank from Switzerland, will incur a loss of $4.7 billion due to the Archegos fiasco and will have to cut its dividend. (Source: “Credit Suisse Takes US$4.7B Archegos Hit, Cuts Dividend,” BNN Bloomberg, April 6, 2021.)
$116-Trillion Notional Worth of Interest Rate Derivatives
Now back to the derivatives market.
You may not know this, but there are many derivatives in the U.S. financial system.
As of the fourth quarter of 2020, banks in the U.S. had derivatives with a notional value of $163.8 trillion. Here’s the kicker, the vast majority of these derivatives were concentrated in interest rates: $116.0 trillion notional worth, or 70.8% of all derivatives. (Source: “Quarterly Report on Bank Trading and Derivatives Activities: Fourth Quarter 2020,” Office of the Comptroller of the Currency, last accessed April 7, 2021.)
Could Something Break?
Dear reader, at the moment, there are a lot of questions about where interest rates are going.
We have one side that says interest rates need to go higher because inflation is picking up in the U.S. You will see the effects of this narrative on the yields of 10-year U.S Treasury Notes. Yields have skyrocketed in a matter of a few months. Essentially, we’re back to where we were prior to the COVID-19 pandemic.
On the other hand, the Federal Reserve continues to say interest rates and inflation aren’t going anywhere for the next few years, and we’re going to be fine.
With all this, you must ask: Is there a possibility that some banks are on the wrong side? Remember, derivatives involve two parties. As mentioned earlier, there’s $116.0 trillion notional worth of derivatives backed by interest rates. What will happen if just five percent to 10% of them go in the wrong direction?
That alone could cause a financial crisis very quickly.
We’ve learned yet another lesson from the Archegos fiasco that derivatives could create economic problems. There’s been a series of events in which derivatives created a massive financial crisis. This time, it likely won’t be different.