by Doug Noland

I don’t believe we can overstate the role derivatives have played – within the markets, but also throughout the real economy. They’re ubiquitous – institutions, corporations, investment managers, and even individual investors all fell in love. I’ve already seen ample evidence that derivatives will be at the epicenter of unfolding financial crises. They’re certainly worthy of keen analytical focus.

There are serious fallacies embedded in the derivatives universe that I expect to be revealed with major consequences.

First, derivatives operate under the assumption of liquid and continuous markets. Meaning, derivatives players assume they’ll always be able to buy and sell in orderly markets to hedge exposures to contracts they’ve written. Yet centuries of history are unequivocal: markets invariably suffer through bouts of illiquidity, discontinuity, panics and collapses.

So, how have derivatives markets flourished for three decades, quickly recovering from multiple crises? There’s one simple answer: central banking and the evolution of market backstops – more recently to the point of egregious monetary inflation.

Keep in mind how things operated over the past cycle: Loose money would fuel a Bubble, the Bubble would burst, and only looser money restored Bubble dynamics to fuel the next even bigger Bubble. This cycle repeated to the point of an insane $5 TN pandemic QE onslaught, stoking the so-called “everything Bubble” and history’s greatest mania.

Over the past decade, not only did the “granddaddy of all bubbles” go global, it also infected the foundation of finance – central bank Credit and government debt. With consumer price inflation now a serious issue for central bankers, tighter monetary policy is hitting a dangerously fragile world.

Myriad Bubbles are faltering outside central bank control, and evidence is mounting that global policymakers have lost the capacity to ensure liquid and continuous markets. As such, we have to question whether colossal derivatives markets, as we’ve known them, will be viable in the unfolding environment.

Buying inexpensive market insurance has been fundamental to so many strategies. It has been central to leveraged speculation and risk-taking more generally. If insurance is readily available and cheap, why not take on more risk and leverage?

And this gets back to derivative market fallacies. The fundamental issue is that market losses are uninsurable. Insurance companies provide protection against random and independent events. Years of actuarial data create the ability to accurately forecast and price for future losses – for automobile accidents, house fires, healthcare expenses, death and so on. Insurance companies price policies and hold reserves for expected future claims.

Market losses are categorically neither random nor independent. They come in waves, with unpredictable scope and timing. Moreover, those that sell market protection do not build reserves against future losses. Instead, they use sophisticated trading programs and buy and sell instruments in the marketplace to provide the necessary cashflow to pay on derivatives written. In particular, when a derivatives dealer writes market protection, the strategy dictates they sell instruments into a declining market to ensure they have the resources to pay on losses. This creates the clear potential to unleash cascading sell orders and a market crash.

And we’ve seen this play out repeatedly, from “portfolio insurance” back in 1987 to just last week’s near crash of the UK bond market. Recall also how in March 2020, the Fed had to make several announcements of ever larger QE programs to finally stem the waterfall of sell orders – in stocks, bonds, and ETFs shares.

The Fed resuscitated the Bubble, with speculative excess and leverage growing only more problematic. And the greater the scope of market risk, the more dangerous derivatives become.

There’s a perception these days that it’s possible to just buy derivative insurance and lock in gains from the great bull market. Economists of old referred to the “fallacy of composition.” Simplistically, what works for one individual has much different consequences if adopted by the group. Right now, I think much of the marketplace believes it can use derivatives to mitigate market risk.

Yet it’s impossible for the broader market to hedge against losses. There’s simply no place to offload tens of Trillions of market risk. No one has the wherewithal to absorb such losses. And if a large segment of a market hedges risk in the derivatives marketplace, those hedges create systemic crash risk. If the market breaks to the downside, the writers of this market protection will be forced to aggressively sell into a collapsing market. If not for QE, derivative markets would surely have collapsed in both 2008 and 2020.

And, again, this is not some theoretical proposition. This dynamic unfolded last week in the UK gilt market. Aggressive Bank of England intervention thwarted a market collapse, but in the process market fragilities were revealed.

Over the years, I’ve shared a flood insurance analogy. Picture a sleepy little village on a pristine river, where a long drought encouraged local insurance companies to write a few policies for waterfront development. As the drought lingered, more entered the flood insurance market to capture some of the easy profits. Building along the river started to boom. Of course, many wanted in on the action, with new insurance operators sprouting up on every corner. Curiously, they actually had no intention of ever paying a claim. They were writing policies and immediately booking the profits, with the plan of moving quickly to offload exposure in the bustling reinsurance market in the unlikely occurrence of torrential rainfall.

The moral of this story is that an extended period of tranquility – a long drought – distorts risk perceptions and market prices, while inviting destabilizing speculation. Effects are both financial and economic.

It’s a sad tale, unfortunately.  When torrential rains finally arrived, the crowd of insurance speculators rushed to offload their risk. Panic ensued. There was no one willing and able to write policies, and the reinsurance marketplace collapsed in illiquidity. Importantly, the amount of lavish building all along the river had risen exponentially – all because of the insurance market Bubble. After the flood, scores of so-called “insurance companies” collapsed, and most policies were worthless.

Pondering the current environment, I’m updating my analogue. After the first flood, the local government bailed out the insurance companies, built a dam up river, and handed out a lot of money for local residents to rebuild. Eventually, however, the dam proved incapable of holding back the water. There was another flood, a bigger bailout and only more generous handouts. After multiple rounds of this over a few decades, everyone came to believe risks could simply be ignored. Just build your dream home and place your faith with local government officials.

Complacent townsfolk were oblivious to a momentous predicament. The government had reached its limit in holding back the water. There was no place on the river for additional barriers, and serious structural issues made it too risky to continue to add to the height of existing dams. Understandably, the attention of local officials shifted from supporting insurance and building booms, to the myriad structural issues and risk of a catastrophic domino dam collapse.

The ending to this tale has yet to be written. Do the townsfolk start losing confidence in the local government’s capacity to sustain the boom? Do the townspeople realize there’s no capacity for additional dams? Do they worry about the insurance companies and their policies? One thing’s for sure, the rainfall is unrelenting.  All the dams have reached maximum capacity.

Importantly, the boom reached a point where confidence turned fragile – confidence in the local government, confidence in the insurance market, as well as the economy. The reinsurance market began to malfunction, forcing the speculators to back away. Flood insurance became increasingly difficult to get and more expensive. Even before the rains, the building boom faltered.

The message from my update: Perceptions can change with enormous ramifications. After years of good times, the townspeople came to believe the local government had control of the river flow. Heck, many thought they could control the weather. Some refer to a “Lehman” or a “Minsky moment.” I call it the “holy crap moment”. Suddenly, things are not as we thought; they might be spiraling out of control, and our government benefactor no longer has an answer.

I look at the world today and see things spiraling away from the control of central bankers and policymakers.

Part III: The Unfolding

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